I had two interesting engagements recently wherein I was asked to value variable executive equity compensation. One of the projects was for tax/fair market value purposes, and the other was for financial reporting, to determine the contingent liability associated with the equity comp.
In the first case, for tax, I looked at the equity, or Class B shares of a private subsidiary of a public parent where a purchase price was determined based on trailing EBITDA. The equity compensation (class b shares) worked like this, the Company had the right in 4 years to call the securities and the shareholder (my client, “the executive”) had the right in 4 years to put the securities back to the Company. I wasn’t exactly certain how to value these “options,” but thought Black-Scholes or Binomial model would do the trick, until I spoke with some wise colleagues, Annika Reinemann (Cogent Valuation) and Patrick McFarland (EKS&H).
My counterparts brought to my attention that these Put and Call rights weren’t options at all, but simply terms used to describe an expected transaction, or a purchase price. The so-called Put preserved the executive’s right to sell shares back to the issuing Company (his employer), and the Call enabled the Company to buy the shares from the executive (my client). However, no set exercise price had been established, rather a variable purchase price was described in the subscription agreement, which applied equally to both rights. In other words, the terms used to describe the class b shares were in fact more like a Buy/Sell Agreement, than equity compensation, per se.
The purchase price for the class b common stock was described as a function of trailing 4-year EBITDA. Rather than use an option calculation to come up with the value of options, I simply calculated the future purchase price for both the Put and Call, at some future date, based on forecasted trailing EBITDA, and discounted the purchase price back to present value using a WACC. For the value of the class b restricted shares, I split the calculated value equally between the derived put and call purchase prices.
Since these were restricted shares, I included some reference to Revenue Ruling 77-287. Specifically stating, the valuation was conducted in consideration of the guidance provided in Revenue Ruling 77-287, “Valuation of Securities Restricted from Resale,” which amplifies Revenue Ruling 59-60 by setting forth guidelines for the valuation, for Federal tax purposes, of securities that cannot be resold, because they are restricted from resale.
The second project was done for financial reporting, and it posed a bit of a challenge, because the subject company was publicly traded (OTC), and we were being asked to value non-qualified stock options, which represented a contingent liability. Our project would have fallen under ASC 718 (formerly, SFAS 123r), which is generally carved out from the definition of fair value provided in ASC 820 (formerly, SFAS 157).
Had we valued the equity under ASC 718, we would have relied exclusively on the company’s public market price. However, due to the relatively thin trading volume that had historically occurred in the subject company, we viewed the public market price as a misleading data point. For example, in one week the stock traded for $0.75 per share and later that same week for $60 per share. Fortunately, ASC 820 provides a process of estimating fair value when the volume and level of activity for an asset or liability has significantly decreased, and includes guidance for identifying circumstances that indicate a transaction is not orderly.
We examined the market for the company’s common stock to determine whether it could be appropriately categorized as active or inactive. After making the determination that the market was clearly inactive, we relied upon the most reasonable alternative inputs to develop the fair value of the common stock. Our assessment of an inactive market for the company’s common stock was made on the basis of several factors, including trading volume, price volatility, prevailing bid ask spreads, and various other impediments to market participants seeking to transact in the common stock.
Ultimately, in determining our value for the common stock, we relied upon the most reasonable alternative inputs readily available, which included the public market price, the implied value of the common stock in two recent private offering transactions, and we utilized the income method for valuing the company’s equity, based on a discounted cash flow analysis.
Our task in this matter was to value the contingent liability associated with the equity compensation. Specifically, the option grants were contingent on the company reaching certain market capitalization milestones. For example, once the company reached $100 million in market cap, the executives would receive 100 thousand common shares. After determining the equity value of the company using the Level I, Level II, and Level III inputs, as provided in ASC 820, we were able to apply a simple Black-Scholes formula to come up with the contingent liabilities associated with the company reaching its milestone events.
In running our Black-Scholes analysis, we represented the stock price with the company’s calculated equity value, and the exercise price was represented by the market capitalization hurdles provided in the subscription agreements for the contingent shares. Since our project was designed for financial reporting purposes, we applied simulation, via Crystal Ball, to all of our variables to come up with sensitivity. During the audit review process, I was told that, for the purposes of financial reporting, sensitivity is relevant for DCFs, and that’s about it. That’s an interesting point, I’d like to confirm.