Under the Family Law Act, when spouses separate they are required to equalize assets. Where a spouse has received employee stock options (ESOs) as part of their compensation, these assets are subject to equalization and reported on the statement of net family property (NFP). This article discusses certain issues that arise in the valuation of ESOs.
Let’s look at the following scenario: You are acting as counsel for Mrs. Jones, who is going through a matrimonial separation. She claims an ESO asset on her NFO statement of $100,000; however, her husband believes she has undervalued the ESOs and will not agree to the proposed equalization payment.
How do you assist the Joneses in settling their dispute?
The first step is to understand the factors that impact the value of ESOs. What is an ESO? Options represent the right to acquire shares from a company at a fixed price for a limited period. Employers may grant ESOs as part of a remuneration package. ESOs differ from publicly traded stock options as they are not transferable and cannot be exercised until they vest, thereby decreasing their liquidity and value. depending on the ESO agreement in force, vesting occurs when the employee reaches certain performance milestones and/or a specified amount of time has lapsed.
What is the value definition applied to ESOs?
The primary value definition used is fair market value (FMV); however, this assumes that the option in question could be sold in an open and unrestricted market. This is not the case as ESOs are not transferable. For family law purposes, the value definition adopted for ESOs is value to owner. The value to owner is the economic advantage to the owner or the measure of loss to the owner, if the asset was removed. The value to owner of an ESO is calculated based on the option value of the company, which can be calculated by using a formula such as Black-Scholes, subject to various discounts and adjustments discussed below.
What are the inputs to the Black-Scholes formula?
The inputs to the Black-Scholes formula include:
- Stock price
- Exercise price
- Expiry date
- Dividend yield
- Risk-free rate
The inputs with the most subjectivity include stock price and volatility. In particular, in privately held companies, the stock price and volatility may not be readily available. Valuation procedures and analyses may be necessary to determine the FMV of the underlying shares and the related stock price input. Volatility is a measurement of the fluctuation in stock price. As private companies do not trade on a stock exchange, measuring volatility is not possible, and selecting a nil volatility is not appropriate. Volatility of an index or comparable public companies are often used as a proxy for the volatility of a private company.
What factors impact the value of ESOs?
The value of the options as determined by the Black-Scholes option pricing model will need to be adjusted for the specific characteristics of a particular ESO plan. Plans to compensate employees vary widely across companies, with compensation structures that may be based on factors such as seniority, company performance milestones, or contingent on performance goals. The stipulations of each plan must be considered to determine the impact on value.
If Mrs. Jones’ ESOs are unvested at the date of separation, we apply a discount for vesting risk to reflect the risk that Mrs. Jones may not reach the specified vesting milestones, or she may not be employed at the time the ESOs vest.
If Mrs. Jones’ ESO agreement stipulates that her ESOs would be cancelled should she be terminated or resign, an additional discount is applied to reflect the probability that Mrs. Jones will not be employed during the period from the time the ESOs vest to the expiry date.
Mrs. Jones is taxed on the profit earned on her ESOs, which is often inclusive of a stock option deduction of 50 per cent of the taxable profit. The tax liability arises at the expected time of exercise, which is normally the expiry date. This future tax liability is therefore discounted to present value.
Contingent disposition costs
Should there be brokerage fees incurred upon disposition, they are deducted from the value of Mrs. Jones’ ESOs. The disposition cost liability arises at the expected time of exercise, which is normally the expiry date. These contingent disposition costs are therefore discounted to present value. The best way to assist your clients in the determination of value of ESOs, or any other complex remuneration package, is to appropriately consider discounts associated with the ESOs as compared to publicly traded stock options, and work with a valuator to provide independent advice of the valuation.