How to Comply with the SEC’s New Pay Versus Performance Guidance

The SEC clarified its position on acceptable methods for estimating the expected term of executive options for compliance with the SEC Pay Versus Performance (PvP) disclosure requirements. Shortcut approaches or the use of the simplified method will not be acceptable, and your organization may need to consider the use of more refined approaches to estimating the expected term and value of executive options.

Background on the PvP rules

In August 2022, the SEC introduced enhanced disclosure requirements to provide information on the relationship between executive compensation and financial performance. They require companies to remeasure the fair value of unvested stock awards at the beginning and end of each disclosed period using GAAP-consistent methodologies.

For plain vanilla stock options, the Black-Scholes model is commonly used to measure fair value at the grant date under GAAP. Many companies use the simplified method to calculate the expected term, a critical input for the model. The expected term represents the period during which options are expected to be outstanding before they are exercised or expire.

The simplified method — outlined in Staff Accounting Bulletin (SAB) Topic 14 — is an alternative for estimating the expected term when there is a lack of sufficient company-specific or comparable company data related to option exercise activity. It calculates the expected term as the midpoint between the weighted average vesting term and the contractual term, eliminating the need for estimates or judgment.

What’s new with PvP

On September 27, 2023, the SEC issued interpretations to help companies comply with PvP requirements. In a nutshell, here’s the impact of the new rules:

• Companies that have relied on the simplified method outlined in SAB Topic 14 will need to reevaluate their valuation approach if their options no longer meet the criteria for plain vanilla options as required by the PvP rules at re-measurement dates.
• When options no longer qualify, the use of shortcut approaches or the simplified method will not be suitable.
• In these situations, a more sophisticated valuation approach, such as a lattice model, will be necessary to meet regulatory requirements.
• The lattice model offers a more refined and comprehensive method for valuing executive options, considering factors such as early exercise multiples and changes in market conditions.

The SEC’s stance on estimating expected term for PvP

The SEC’s new interpretations say the fair value of stock awards and option awards must be calculated using a methodology and assumptions consistent with FASB ASC Topic 718. This means companies cannot use non-GAAP-prescribed methods to value these awards.

The SEC specifically states the use of a shortcut approach that subtracts the elapsed actual life from the expected term assumption at the grant date is not acceptable. This approach fails to consider changes in factors like volatility and exercise behavior affecting the expected term assumption.

The SEC clarifies the simplified method described in SAB 14.D.2 should not be used to determine the expected term for options referred to as plain vanilla if those options no longer meet the plain vanilla criteria at the re-measurement date, such as when the option is out-of-the-money.

Considering it’s unlikely for any executive stock options to be at-the-money at the beginning or end of the covered periods requiring fair value remeasurement under the PvP requirements, the SEC essentially says the simplified method is not acceptable to estimate the expected term for executive stock options in compliance with PvP.

The Impact on privately held companies

The calculation of expected term is not new and is discussed in depth in ASC 718 and SAB Topic 14. While the SAB provides a simplified method for estimating the expected term for plain vanilla options, it specifically states it’s only acceptable when:

• The company does not have sufficient historical exercise data to provide a reasonable basis to estimate expected term due to the limited period its equity shares have been publicly traded.
• The company significantly changes the terms of its share option grants or the types of employees who receive share option grants where its historical exercise data may no longer provide a reasonable basis to estimate expected term.
• The company has or expects to have significant structural changes in its business where its historical exercise data may no longer provide a reasonable basis to estimate expected term.

Other ways to estimate the expected term and fair value of executive options

If the simplified method is not available, there are alternative approaches to estimate the expected term and fair value of executive options. Alternatives include:

• Historical exercise behavior — Examining how employees have exercised prior stock options helps determine assumptions and models of anticipated employee behavior.
• Vesting and expiration dates — The timing of option vesting and expiration dates are considered when estimating the expected term. The time to vest sets a minimum expected term and the time to expiration sets a maximum expected term.
• Employee-specific factors — Demographics of employee populations may affect employees’ exercise behavior.
• Market conditions — Market conditions such as stock price volatility and trends are considered when estimating the expected term.

If a company’s historical data is insufficient, the company may refer to other publicly available data, such as academic research or information included in the disclosures of similar companies.

Should you consider a lattice model?

Considering the use of a lattice model could be a worthwhile option. The lattice model is a valuation technique observed to be effective for valuing non-plain vanilla options, especially when combined with early exercise multiples observed in company-specific employee exercise history and academic studies.

The model considers expected employee exercise behavior and can also incorporate expected changes in volatility and exercise behavior to determine the fair value of options. Unlike simpler methods like the Black-Scholes model, lattice models offer a more nuanced valuation by considering a range of possible future scenarios. Given the SEC’s interpretations, it’s likely lattice models will be increasingly used to assist in the valuation of executive options for PvP compliance purposes.

How we can help

Adapting to evolving regulations and employing appropriate valuation methods and inputs is crucial for accurate and compliant valuation of executive options. By reassessing your approach and considering more refined models, your organization can navigate the changing landscape and meet obligations effectively.

CLA’s professionals have the experience you need to help in estimating the fair value of stock awards and option awards to assist with compliance with PvP. Contact us to learn how we can help.