ESOARS to Offer Market Pricing of Employee Stock Options?
On January 25, 2007, the SEC sent out a letter generally approving the design of a new derivative security developed by 'Zions Bancorp called ESOARS (Employee Stock Option Appreciation Rights Securities) that could effectively create a market pricing mechanism for employee stock options ("ESOs"). While we must be careful not to misinterpret this news (the SEC did not actually approve this valuation method for immediate practical use in SFAS 123R compliance), there are some interesting implications that merit consideration.
Here is some background: companies have been required to expense the fair value of ESOs granted since the latter half of 2005, and this requirement has significantly impacted reported earnings for companies that use ESO grant compensation heavily. According to a recent article in Forbes, if the results from the ESOARS test auction are reasonably accurate, Electronic Arts, Adobe, and eBay could potentially increase pretax profits by 43%, 11%, and 10%, respectively, through the mitigation of ESO expense. Based on most recent quarterly pretax profits, this increase would represent an additional $70 million in pretax earnings for these three companies alone. While the requirement to report option expense is conceptually sound (companies granting ESOs do incur a real cost), some analysts believe that the current option valuation methods prescribed by the SEC (Black Scholes or binomial option-pricing models adjusted for expected life) overstate ESO cost because these models were developed for the pricing of publicly traded stock options. Results of a test ESOARS auction held by Zions in June 2006 suggest that the fair value of ESOs may be substantially lower than that implied by conventional stock option valuation models, which is music to the ears of managers of business struggling with ESO expense - if it ultimately provides a reasonable basis for recording lower option compensation expense.