The following article is adapted and reprinted from the M&A Tax Report, Vol. 10, No. 10, May 2002, Panel Publishers, New York, NY.

VALUING STOCK OPTIONS: GUIDANCE IN THE MAZE

By Robert W. Wood, San Francisco

Valuing stock options has long been a headscratcher. Although there are a variety of contexts that may require one to value stock options, one terribly important application arising in the acquisition context concerns the golden parachute rules. One must value compensatory stock options, after all, if one is to determine whether the golden parachute rules apply (including the excise tax on excess parachute payments).

The IRS in Revenue Procedure 2002-13, has provided guidance. This revenue procedure includes a safe harbor for valuing compensatory options for purposes of the golden parachute rules. The revenue procedure is effective April 26, 2002.

Basic Rule

A taxpayer can value a compensatory stock option using any valuation method that is consistent with generally accepted accounting principles, including Statement of Financial Accounting Standards No. 123 (FAS 123), as long as it takes into account the factors listed in Prop. Reg. §1.280G-1, Q&A 13. If the stock option is one that could otherwise be valued under Revenue Procedure 98-34, 1998-1 C.B. 983, because the options satisfy the definition of compensatory stock options in Section 3 of Revenue Procedure 98-34, then the valuation will not be considered consistent with generally accepted accounting principles unless the valuation follows Revenue Procedure 98-34 or the new safe harbor method of Revenue Procedure 2002-13.

What is the safe harbor? The revenue procedure uses the Black-Scholes model, taking into account (as of the valuation date) the following factors:

The safe harbor value of the option is calculated as the number of options multiplied by the spot price of the stock, multiplied by a valuation factor determined using the listed factors and reflected in the table in the appendix to Revenue Procedure 2002-13. Other relevant factors, including risk-free rate of interest and assumptions related to dividend yields are included in the table in the appendix.

Recall that Section 280G denies a deduction for any excess parachute payment. An excess parachute payment is generally defined as an amount equal to the excess of any parachute payment over the portion of the disqualified individual's base amount. A parachute payment is any payment in the nature of compensation to (or for the benefit of) a disqualified individual, if the payment is (a) contingent on a change in ownership of a corporation, the effective control of a corporation or the ownership of a substantial portion of the assets; and (b) the aggregate present value of the payments in the nature of compensation which are contingent on such change equals or exceeds an amount equal to three times the base amount. Significantly for purposes of this guidance, a payment in the nature of compensation (which needs to be evaluated under Section 280G), includes the transfer of an option, without regard to whether the option has a readily ascertainable fair market value within the meaning of Section 83.

Volatility

One of the important aspects of determining value is volatility. The revenue procedure states that the taxpayer must determine whether the volatility of the underlying stock is low, medium or high. Low volatility stock has an annual standard deviation of 30% or less. Medium volatility stock varies between 30 and 70 percent. A high volatility stock has an annual standard deviation of 70% or greater. If the stock is publicly traded on an established securities market (or otherwise), the expected volatility of the underlying stock used in this revenue procedure is the volatility used for purposes of complying with FAS 123, and disclosed in the most recent financials.

If the stock is not publicly traded on an established market (or otherwise), but the stock is required to be registered under the 1934 Act, the volatility for the stock is assumed to be the same as the volatility for a comparable corporation that is publicly traded. How does one determine comparability? You should compare relevant characteristics such as industry, corporate size, earnings, market capitalization and equity structure. If the stock is not publicly traded and the corporation is not required to register under the 1934 Act, the taxpayer must assume medium volatility. If the stock is not required to be registered under the 1934 Act, but the corporation voluntarily registers its stock and its stock is publicly traded, the corporation must use the volatility of the underlying stock.

Exercise Price vs. Spot Price

Another factor is the spread between the exercise price and the spot price. One calculates this (according to the Revenue Procedure) by dividing the spot price by the exercise price, and subtracting one. If the stock is not publicly traded, the determination of the spot price has to be "reasonable and consistent with the price, if any, otherwise determined for the stock in connection with the transaction giving rise to the change in control." The revenue procedure says you can round (down) to the next lowest interval. However, note that if this spread between exercise price and spot price exceeds 220%, the safe harbor valuation method cannot be used.

Term

The term of the option is fairly straightforward. The term is simply the number of full months between the date of the valuation and the latest date on which the option will expire. For purposes of determining the term factor under the table, the number of full months may be rounded down to the next lowest six month interval. If the term of the option exceeds ten years, then the safe harbor valuation method cannot be used.

Example: Corporation A undergoes a change in ownership or control within the meaning of §280G(b)(2). Contingent on the change in ownership or control, Employee E, a disqualified individual, vests in 100 stock options in Corporation A stock, each of which has a remaining term fo 60 months after vesting. The volatility for Corporation A is 50%. Therefore, the stock has medium volatility. At the time of the change in ownership or control, the value of the stock is $24 (the spot price). The exercise price under each of Employee E's options is $20. Therefore, the factor based on spread is 20% (24/20-1). The value of the options under the safe harbor valuation method described in Section 4 of this revenue procedure is $1,219.20 computed as follows: 100 options times the spot price of $24 times 50.8% (the factor in the table in the Appendix for a medium volatility stock with a 20% spread factor and a 60-month term). Corporation A is permitted to use this value as the value of the payment under §1.280G-1, Q&A 13.

Conclusion

All of this may seem like heavygoing, and indeed, a good part of it is. As just one example, determining what company is comparable to another seems sure to invite disputes. However, some guidance is always better than none.

Valuing Stock Options: Guidance in the Maze, Vol. 10, No. 10, The M&A Tax Report (May 2002), p. 1.