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Are estate planners shortchanging their clients by applying obsolete and inappropriate valuation rules that overvalue transferred stock options? Regardless of how you feel about the ability of older valuation methods to produce accurate estimates of fair market value in the past, as market realities have changed, the valuation methods specified in Rev.

For many clients, the old methods produce option prices far in excess of fair market value.

A Fair Market Approach To Valuing Stock Options

And, with option grant plans from 4, companies covering more than 9 million plan members as of 1 — and with more and more plans allowing inter-family transfers — the stakes for calculating accurate valuations are high. The relevant revenue procedures are based on the valuation rules of Statement of Financial Accounting Standards No. The financial accounting standard prescribes valuation methods based on standard option-pricing models, adjusted for the historical experience of the issuing entity with early-exercise behavior.

However, SFAS R also says that "the best evidence of fair value for employee stock options is observable market prices of identical or similar instruments in active markets. However, for the relevant revenue procedures, the tension is even greater, as the definition of fair market value is much more explicitly market-based. Because they lack the liquidity of the publicly traded options the valuation models were designed to price, employee stock options are worth significantly less.

Accounting Valuations First, start with an understanding of what SFAS R allows, and the recognition that different valuation methods serve different purposes.

FAS R Reporting: Recodified and Explained | AccountingWEB

Further complicating valuations, the standard of value in financial accounting is "fair value" while the standard of value in tax cases is "fair market value" The most important difference between an SFAS R valuation and the true fair market value of illiquid options is that SFAS R does not allow discounts for illiquidity.

Instead, SFAS R requires that companies estimate the time-to-exercise of options granted, based as much as possible on actual early-exercise behavior of plan participants. Black-Scholes may provide accurate values for short-term publicly traded options, but it overvalues stock options that are not publicly traded. The Black-Scholes formula, in its simplest form, is as follows:. The model relies on these assumptions: While none of these assumptions holds perfectly in real-world situations, they hold well enough to make Black-Scholes the most commonly used model among options traders valuing fully liquid stock options on actively traded stocks.

Known biases in the model are minor and trading software compensates for them automatically. With non-tradable options and warrants, though, the Black-Scholes model overstates prices, often by a wide margin.

Black-Scholes and other SFAS R methodologies are inaccurate, even for financial accounting purposes, because the financial accounting standard rejects the application of a liquidity discount.

For one, early-exercise behavior is highly individual and, further, even the "average" plan participant in very large option grant plans will tend to exhibit highly variable early exercise behavior over time.

Such estimates tend to be conservative and overestimate the expected term. As we shall also see later in this article, even if we could shorten the term accurately, these methods would still overvalue the average illiquid stock option. The illiquidity discount for non-tradable options and warrants varies significantly, depending on how far in the money the option or warrant is.

However, liquidity has value in and of itself, and illiquidity discounts apply to all non-tradable securities, separate from the possibility in the case of options of early exercise.

The "safe harbor" revenue procedures of the IRS — Rev. They generally require use of the Black-Scholes or binomial models, do not allow illiquidity discounts, and place limitations on specification of the inputs to the models.

The volatility of the underlying stock must be based on the volatility disclosed in the financial statement for the fiscal year in which the valuation is made. Likewise for dividends used in the valuation. In determining the factor for the risk-free interest rate, you must use the yield to maturity of zero-coupon U. Treasury bonds as of the valuation date with a remaining term nearest to the expected life of the option. To calculate the expected life of the option, you can use either the foreign currency fixed deposit rates public bank remaining term" of the option, which is the number of years remaining from the valuation date rounded to the nearest tenth of a year, or the "computed expected life," which is calculated by multiplying the maximum remaining term by the quotient of the weighted-average expected life, divided by the number of years from the date the option was granted.

However, the maximum remaining term must be used in many cases, including when:. A second regulation, Rev. Obtaining "Fair Market Value" Rev.

As is common in almost all tax valuation guidelines, Accounting stock options 123r. If the safe harbors calculate values that are significantly higher than fair market value, prudent advisors can, and in many cases should, advise clients to file their returns based on the fair market value of transferred assets, rather than the safe harbor value.

The most accurate way to obtain the "fair market value" of a security, of course, is to sell it. What it sells for is its fair market value. When there is no public market for an asset, the next best thing is an estimate of what it would sell for privately.

Pluris uses real-world transactions accounting stock options 123r LiquiStat to determine "fair market value" for illiquid assets. Unlike prices derived from Black-Scholes and other methods, whether with early exercise or not, prices derived using LiquiStat are based directly on "observable market prices.

For each transaction in the database, we computed the theoretical model value of the warrant, which is the value it fwb stock market hold if both the warrant and the underlying stock were fully liquid and all assumptions of the Black-Scholes model held.

Medians — Data Sorted by Magnitude of Discount from Black-Scholes Make money wahm. The "intrinsic value" of an option stock brokers temple bar warrant is the price it would yield if exercised i.

Note that the average intrinsic value is significantly higher for warrants in the low-discount quintiles, while the average moneyness is significantly lower for warrants in the high-discount quintiles. These real-world transactions show that non-traded options or warrants would never sell cuenta demostracion forex full Black-Scholes value, using volatility inputs from the market and the full time to expiration.

The size of these discounts is evidence that Rev. In the LiquiStat database, illiquidity discounts are calculated stock market cmg both a the theoretical option value and b the theoretical time value of each warrant the full theoretical value minus the intrinsic value.

Such discounts are far greater than discounts typically derived by adjusting the Black-Scholes inputs for shorter expected terms. The LiquiStat database represents the first-ever study of real-world empirical data on transactions in non-traded options and warrants.

How much money does a bartender make believe there are two reasons why the discounts for options and warrants are so high:. Time value discounts in the LiquiStat sample average about 1. The longer the time to expiration, the higher the volatility, and the further out of the money an option is, the larger the discount.

Other Studies That investors will not pay full Black-Scholes values for non-traded options and warrants has been predicted and analyzed in several theoretical papers. These papers from the academic literature are generally confirmed by the analysis of the LiquiStat database.

Summary of Statement No.

Together, the empirical data and theoretical papers provide strong evidence that market-based valuations are better than the rules-based approaches of the relevant revenue procedures and financial accounting standards.

Most published work focuses on the behavior of holders of illiquid stock options mostly, employee stock options and provides proof both that Black-Scholes and other methods that treat options as if they are fully liquid produce valuations that are too high and that even adjusting for early exercise is unlikely to fully account for the illiquidity discount. Kulatilaka and Marcus note that a holder who wants to reduce his option position would sell part of the position.

The evidence is that they do not. Results from the Kulatilaka and Marcus study imply that historical exercise patterns, since they are driven by past stock price performance, are a poor guide for future exercise patterns. For example, Kulatilaka and Marcus derive a model where early exercise is driven by the need for diversification. While the value of traded options always increases with volatility, Kulatilaka and Marcus found that the value of illiquid options may sometimes decrease with increasing volatility, depending on the level of investor risk aversion, because higher volatility may lead to earlier exercise.

A study by Hall and Murphy found that executives demand large premiums for accepting stock options in lieu of cash compensation, because options are worth less to executives than they cost to the issuing firm. In fact, in this model, assigned values in some cases are below intrinsic value.

Finally, there is also specific evidence that the FASB and IRS methods of shortening the time to exercise cannot fully account for the effect of limited liquidity. A study by Finnerty shows that assuming early exercise alone provides discounts for lack of marketability for employee stock options that are too low and tends to overstate fair market values.

Finnerty finds that employee stock options, at grant, are worth approximately half their Black-Scholes values. Finnerty concludes that extrapolating exercise behavior from past stock-price patterns that may not be repeated produces inaccurate values.

Professionals who rely on accurate values to comply with regulatory requirements, and who want to ensure that their clients are paying no unnecessary taxes, would do well to consider a valuation methodology that is based on true market values, rather than hypothetical exercise periods. For simplicity, the differences between actual and model prices are referred to herein as "illiquidity" or "marketability" discounts. The discounts may, in fact, represent any number of divergences from the theoretical model values in addition to just liquidity issues for example, the Black-Scholes formula may consistently overvalue warrants with long time to expiration.

However, we believe that the lack of marketability for these securities is the cause of the majority of the discount. The goal, of course, is not to separate various elements of the warrant discount, but to arrive at workable valuation models for non-traded warrants. This we can do without differentiating between the various causes of the discount.

Hall and Murphy "Stock Options for Undiversified Executives" Journal of Accounting and Economics 33 Feb p. Finnerty "Extending the Black-Scholes-Merton Model to Value Employee Stock Options" Fordham University working paper, January Who We Are How Pluris differs: Pluris' unique secondary market transaction data; Pluris' original research on discounts for illiquid securities and business interests; a staff with the expertise for the job.

Ask one of our experts! Rajesh Madan Cutera, Inc. A Fair Market Approach To Valuing Stock Options. Your name and email address:. Separate each email with a comma: This personal message will appear within the email: Enter digits seen at right. Market Awaits Shortened Holding Period. How to Get a Fair Price. Home Who We Are What We Know Who We Serve Assets Valued Talk To Us Careers Sitemap. Table 5 — LiquiStat Warrant Trades.

Time to Expiration Years.