Updated: Feb 6
- a valuer's bonanza?
Today's post is by Shân Kennedy (MA FCA), a Chartered Accountant and recognised expert in IFRS, UK GAAP and valuation issues.
Her background includes 20 years working for a Big 4 practice, with 4 years at the then Accounting Standards Board as the Project Director responsible for Goodwill and Intangible Asset accounting and the associated Impairment Review - her work is embedded in relevant current UK GAAP and IFRS. She is regularly engaged by clients to provide valuation advice in the context of financial reporting.
As an independent practitioner, she has provided advice to the Financial Reporting Council, the International Valuation Standards Council and to the ICAEW, as well as to numerous clients in the UK and overseas. She is also a contributing author to Practical Share Valuation, 7th Edition.
Over the last 15 or so years, changes to both UK GAAP and IFRS have resulted in share option valuations being needed in certain situations for the purpose of financial reporting – i.e., to include in a set of accounts.There is no doubt that these, as well as the intangible asset requirements following an acquisition, have established healthy new lines of business for valuation consultants.
But it isn’t quite the bonanza it may at first seem…….
“Before leaping headlong into signing engagement letters and reviewing comparator company volatility figures, it is critical for the valuer to understand why the share options were issued and whether they do, indeed, need to be valued for the accounts.I have received several recent requests to perform urgent share option valuations only to find on perusal of the request, and often after trawling through quite lengthy option agreements, that the options in question don’t need to be valued for the accounts.I have looked below at a few situations I have come across recently."
Options must be valued when they are issued as part of a reward scheme, i.e., they are effectively part of certain employees’ remuneration. In these cases, IFRS 2, Share-based Payment, and FRS 102, Section 26, Share-based Payment, detail effectively the same requirements. So, if you find that the reason for the valuation is because options (and the same would apply to direct share issues rather than options) were issued as part of a reward scheme, you are off to the races and can start to gather information with a view to providing a fee quote to your client, deciding which option valuation model is most appropriate and commencing work.
However, do bear in mind that, for the most part, these valuations are required only once and that is at the grant date, so the only accounts for which a new option valuation will be needed are the ones whose financial year contains the grant date.
There are some spreading requirements for the P/L accounts in future years that clients may ask for assistance with, but these do not involve further use of option valuation models.
Another situation where an option valuation will be required, and in this case every year-end, is when the company owns a call option over a non-controlling stake in another company. If a company owns share options in another company, which if exercised would amount to a non-controlling stake and it doesn’t already have a stake in that company, the share options are generally measured at fair value every year-end. In practice, not much work of this nature is referred to valuers. It tends to be financial institutions, such as banks or insurance companies, that own such options and they have plenty of in-house staff to perform valuations. Occasionally, however, a corporate will own such a stake and request option valuations from an external valuation consultant.
A more complex situation is if a company already owns a controlling stake and has a call “option” over some, or all, of the remaining non-controlling stake. Cases arise where a so-called option isn’t really an option – it is a requirement to purchase the remaining stake within a set period. The “option” agreement needs to be read carefully to ensure you have understood whether it is really an option or a forward commitment to buy shares, with obvious consequences for whether an option pricing model needs to be used.
Care is required in the case of put options.
If a company is the “owner” of a put, giving it the right to sell shares at a fixed price during a stated period, that right can be valued using the same option pricing models as a call option – i.e., Black & Scholes, Binomial or Monte Carlo simulation. Again, in the case of a non-controlling stake, such an option would generally be measured at fair value in the accounts.
However, for every owned put, there is a counterparty which wrote the put and must account for a “written” put.
In this case, the client company has agreed to buy back shares at a given price over a specified period. Written puts, although needing to be recorded at fair value in the accounts, are not valued using an option pricing model. They are, effectively, liabilities as, during the exercise period, the put owner can sell the underlying shares to the client company which must then pay the exercise price. Written puts are not usually valued at less than the discounted exercise price. Although a valuation exercise is required to find the appropriate discount rate and perform the discounting, no option pricing model is involved. The measurement of the liability is linked directly to the exercise price payable.
... as a way of raising finance, companies sometimes issue share options to parties that may or may not already be shareholders. Provided the counterparties have neither performed, nor are expected to perform, any services in exchange for such options, i.e., they are purely options to invest, there is no option valuation requirement for the accounts. These are issues of capital and, as such, are never accounted for at fair value by the issuing company. There are, however, other accounting and reporting implications, e.g., for earnings per share and disclosure notes.
So, if a potential client invites you to quote for an exercise to value share options, your first step should always be to find out why the share options were issued and to engage with the client and their auditors, and possibly UK GAAP or IFRS advisers, to determine the precise accounting requirement for a valuation, if any.