The SEC announced the adoption of its new pay for performance rules, or Item 402(v) on August 25, 2022, which requires several new executive compensation disclosures around employee equity.
The new rules require all outstanding and unvested awards to be re-valued as of the end of the fiscal year and awards that vest during the fiscal year to be valued on their vest date. The incremental change in fair value from the end of the fiscal year (or vest date if sooner) as compared to the end of the prior fiscal year, is included as Compensation Actually Paid during the year. The guidance states “(3) Fair value amounts must be computed in a manner consistent with the fair value methodology used to account for share-based payments in the registrant’s financial statements under generally accepted accounting principles”. Therefore, it is critical to use a consistent process for pay for performance re-valuation to what was done on the grant date and disclosed in current financial reporting.
The intent of this brief is to highlight the compliance challenge when dealing with awards with monthly vesting. In some fact patterns a single individual could have as many as 37 vesting events in a single year (see Appendix A), all of which need to be re-valued. The intent of this approach is to outline the data challenge and provide reasonable approaches to comply with the requirements. For purposes of this Alert, we will reference the following example.
Example: Company ABC has granted employee stock options every 3/15 since 2018. Every year they have provided 4,800 stock options that vest 25% on the first anniversary, and then an additional 1/48 each month thereafter.
|3/15/2018||4,800||$10.00||25% at 1 year, and monthly after||$4.00|
|3/15/2019||4,800||$8.00||25% at 1 year, and monthly after||$3.20|
|3/15/2020||4,800||$12.00||25% at 1 year, and monthly after||$4.80|
|3/15/2021||4,800||$10.00||25% at 1 year, and monthly after||$4.00|
|3/15/2022||4,800||$14.00||25% at 1 year, and monthly after||$5.60|
1 As calculated compliant with ASC718. The expected life applies the simplified approach of 6.08 years, volatility is based upon a historical period of time commensurate with the expected life and using closing stock prices, they do not have a dividend policy, and the risk-free rate is based upon zero coupon treasury rates commensurate with the expected life.
The first challenge is to organize your data in a way that allows for the calculation of unvested equity as of 12/31/2022, and the 37 vesting tranches that occurred during 2022. Morgan Stanley has created reports in both Equity Edge Online (EEO) and Shareworks to assist. Look for the Valuation Disclosure Detail Report, and is summarized on Appendix 1B (Outstanding and Unvested Report) and Appendix 1C (Vested During Period report).
Now that we have collated the required data for calculating the fair values, we will illustrate how to determine the assumptions that go into a Black-Scholes model (Infinite Equity has discussed some of the considerations in Alert1 and Alert2). Referencing Appendix 1D, the assumptions can be determined as follows:
- Expected Life / Exercise Behavior – For purposes of this calculation, we have applied the “Computed Expected Life” as prescribed in Revenue Procedure 98-34, which applies a 60.83% percentage to the remaining contractual term for all outstanding awards. 60.83% is determined as the original grant date expected life (6.08 years) divided by the original contractual term of 10 years. Read more in Alert 1. This approach is compliant under ASC718, and a reasonable expectation of future exercise behavior.
- Expected Volatility – We have determined the weighted average expected life for all re-valued awards to be equal to 5.03 years. Aggregating all awards into a single weighted average expected life is consistent with grant date practices. We have then developed historical volatility for the last 5.03 years based on closing prices to be equal to 51.22%. This approach eliminates the need to develop a distinct expected volatility for each outstanding and distinct expected life.
- Risk-Free Rate of Return – We have applied treasury rates commensurate with each distinct expected life. The weighted average risk-free rate of return is 2.69%.
- Expected Dividend Yield – The company does not apply a dividend yield, and the assumption is 0% for all re-measured valuations.
Now that the Black-Scholes fair values have been calculated as either 12/31/2022 (or vesting date), then the total “Compensation Actually Paid” can be calculated by offsetting the fair value as of the end of the prior year.
The aforementioned process represents a quick and scalable solution to estimate the fair value for all option awards for purposes of Item 402(v). Despite the fact that this example requires 37 re-measured calculations, there are reasonable approaches to solve for this efficiently. Morgan Stanley is partnering with Infinite Equity to develop the tools to support you with efficient solutions for the new 402(v) executive compensation disclosures. If you have questions about this Alert, contact us, we’re here to help.