Share-based payments (SBP for short) are part and parcel of an attractive compensation package for recruiting and incentivizing employees on an ongoing basis. In this context, SBPs vary significantly in terms of their contractual vesting conditions, which is also reflected in a large number of different modeling approaches for determining fair value.
Under IFRS 2.B4, IFRS 2 generalizes the term "option pricing model" to mean the need to use a mathematical model to determine fair value, and further states under IFRS 2.B5 that, when selecting the measurement model, factors must be taken into account that knowledgeable, willing market participants would consider when selecting the option pricing model to be used. The KPMG IFRS 2 Handbook (2018)1 explains the term "option pricing model" further:
- Closed-form models, such as the Black-Scholes model
The Black-Scholes model is a closed formula and suits the valuation of SBPs that have only a strike price and a specific exercise date. A number of Black-Scholes formulas can be nested for some specific payoff structures; however, closed-form models tend to be unsuitable for options with sophisticated payoff structures. There are also other closed formulas, for example barrier options or options with an American type of exercise. For SBP with market conditions, such as for example the outperformance of an index or a peer group and performance hurdles over an average period, this valuation model is not suitable.
- Lattice models, such as the binomial model
In a binomial model, stock price performance is generated by spanning a binomial tree. More complex payoff structures can be mapped, which arise, for example, due to a cap on the payoff or the SBP’s other market conditions.
- Simulation models, such as the Monte Carlo model
Classically, a Monte Carlo model uses geometric Brownian motion to simulate stock prices. Building on this, more complex payoff structures can be simulated. This type of modeling is typically used by non-capital-market-oriented companies, where the payoff depends on the liquidation preferences stated in the shareholder agreement. Beyond that, the Monte Carlo simulation is also frequently used in capital market-oriented companies with complex market conditions, for example, when the SBP’s payoff depends on a future ranking of the company in a peer group. It is important not to forget that for stable simulation results, sufficient simulations need to be run (>20,000).
The measurement methods described here combine the same input parameters that are explicitly defined in IFRS 2.A:
- exercise price of the option
- (expected) term of the option
- actual price of the underlying shares
- expected volatility of the share price
- expected dividend for shares (if applicable)
- risk-free interest rate for the relevant currency area for the term of the option
It can be challenging to identify or gauge appropriate assumptions for these input parameters. The availability of the relevant data varies primarily depending on an existing capital market quotation of the company. Consequently, a fledgling company without publicly traded shares might not have valid (market) data available to determine the current price and volatility. For the latter value, often a peer group quoted on the capital market is used as a basis. In order to determine the current price of the underlying shares, it is first necessary to establish an company value as of the key date. This can be determined by using either recognized company valuation models, such as discounted cash flow models, multiples models and capitalized earnings value models, or derived from a financing round that has taken place (see AICPA Paper (2011)2). In the next step, to determine the fair value of the share-based payment program, the liquidation preference specified in the Shareholder Agreement for serving the complex capital structure with multiple share classes should be considered. In practice, if an external financing transaction is available, the determination of the company value, the consideration of the payout structure as well as the valuation of the SBP fair value can be performed using the same simulation model. Backsolving is used to calibrate to the value of the share class issued in the financing round, so that the company valuation and the SBP determination are based on identical assumptions of the input parameters.
Apart from this, the allocation of the current company value to the share classes and the derivation of an SBP value without performing a simulation is, in our opinion, not an appropriate procedure as defined by IFRS 2. This procedure is referred to in the AICPA paper as the current value method (or "CVM" for short) and is much more much more closely reflects the "intrinsic value" of the share classes. Put simply, it is only appropriate to apply the CVM if the SBP are exercised in a timely manner, so that it can be assumed that the current company value will not change until the exercise date.
A measurement method derived from the specifications of the standard leads to results that are reproducible by expert third parties (e.g. the auditor) and thus reduces audit risks. Therefore, it is very important for companies to apply a measurement process that takes both the specific design of the SBP program as well as any special features of the reporting company (e.g. equity structure) and the international accounting requirements into account.
No matter how complex your share-based compensation program might be, you can rely on our many years of experience in the areas of program design, accounting and assessment as well as economic impact analyses. Additionally, they have the appropriate methods and tools to provide you with tailor-made support.
Source: KPMG Corporate Treasury News, Edition 124, August 2022
Ralph Schilling, CFA, Partner, Head of Finance and Treasury Management, Treasury Accounting & Commodity Trading, KPMG AG
Marie Czentarra, Managerin, Finance and Treasury Management, Treasury Accounting & Commodity Trading, KPMG AG
Sebastian Gammisch, Senior Manager, Finance and Treasury Management, Treasury Accounting & Commodity Trading, KPMG AG
1 p. 361 A2.100
2 “Valuation of privately held company equity securities issued as compensation“