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Determining Compensation Expense Under SFAS
123(R) -Accounting for Share Based Compensation
Practical Examples
Presented to the Houston Chapter of the NACD May
12, 2005 Presented By Vincent D. Foster Brent J.
Dickey
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SFAS 123 (R) - Overview

• SFAS 123(R) like the International Accounting
  Standards Boards (IASB) rules now requires
  companies to recognize all compensation costs for
  all share-based payments based upon a fair value
  premise (with limited exceptions).
• SFAS 123(R) eliminates the use of Option 25s
  intrinsic value method and now requires both
  public and nonpublic companies to account for
  equity award share-based payments to employees
  (i.e. stock options) based upon a fair value
  premise (with limited exceptions).
• SFAS 123(R) permits nonpublic companies to
  account for liabilities to employees pursuant to
  share-based payments using either a fair value
  premise or their intrinsic value.
• SFAS 123(R) also allows models other than the
  closed-form model (i.e. Black-Scholes) and
  lattice (i.e. binomial or trinomial) models (the
  two most common models in current use), which
  incorporate specified inputs.
• SFAS 123(R) also amends FASB Statement No. 85,
  Statement of Cash Flows, to require that excess
  tax benefits be reported as a financing cash
  inflow rather than a reduction of taxes paid.
• In April 2005, the FASB delayed implementation of
  SFAS 123(R) for 6 months such that calendar year
  companies will adopt the new rules beginning Q1
  2006.

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Types of Equity Awards Impacted by SFAS 123(R)

• Restricted Stock Grant (RSG) - is an award that
  is tied to conditions that the employee must
  satisfy. The most common restriction is
  time-based vesting, which requires the employee
  to remain with the company for a certain length
  of time before full ownership of all of the
  shares is transferred. Departure prior to
  fulfilling the required service will result in
  the forfeiture of the unvested stock back to the
  company.
• Stock Option - a contractual right, or option, to
  buy a certain number of the company's shares over
  a specified time period, paying a price that is
  specified at the time of the grant (presumably
  equal to the stocks fair market value at the
  time of the grant).
• Employee Issued Notes to a Company to Purchase
  Shares the transfer of equity shares to an
  employee for a note that provides no recourse to
  other assets of the employee (other than the
  shares).

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Valuations Required to determine Compensation
Expense Under the Current and New Rules
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Valuation Procedures for Equity awards

• On the grant date, companies (both public AND
  private) must first ascertain what the current
  fair value per share of their equity is if they
  are issuing RSGs or any type of options (assuming
  the options have a strike price equal to fair
  value on the date of grant).
• Next, the companies must determine the fair value
  per share of the equity based compensation
  issued.
• RSG Fair value is typically determined by taking
  minority and marketability discounts.
• Options Fair value is typically determined
  through the use of either the BSOPM or a binomial
  model.
• Employee Notes Fair value is presumably
  determined by treating the notes as an option
  with an increasing strike price and utilizing an
  option model to derive their value.
• The expense of the options must then be
  recognized on a pro-rata basis over the
  underlying service period on the companys
  financial statements.

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Most Common Option Valuation Models Used

• Black Scholes Option Pricing Model - Closed End
• Binomial Model Open End

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Black Scholes- Inputs

• Strike price (exercise price) - the price at
  which the option can be converted to shares of
  stock.
• Expected life of option - time period between the
  grant date and the expiration date of the option.
• Current stock price (underlying price) the
  closing market price of the stock as of the grant
  date.
• Expected dividend yield - estimated based on the
  underlying companys historical dividend yield
  and/or the companys expected future yield.
• Expected volatility - estimated based on
  historical price movements of the underlying
  stock or that of guideline companies.
• Risk-free interest rate - estimated as the rate
  of the U.S. Treasury Strip as of the grant date
  expiring at or as close to the expiration date as
  possible.

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Binomial or Lattice Model - Inputs

• Strike price (exercise price)
• Option Grant Date
• Early-Exercise Date the first date at which the
  option may be exercised (accounts for vesting).
• Option Expiration Date
• Current stock price (underlying price)
• Suboptimal Exercise Factor (see following slides)
• Termination Vesting the model incorporates
  the effects of early terminations and vesting.
• Exit Rate Pre-Vesting The turnover or forfeiture
  rate prior to vesting.
• Exit Rate Post-Vesting The turnover or
  forfeiture rate post vesting.
• Flexible (Changing) Assumptions/Inputs the
  lattice/binomial model allows for expected
  changes in the following inputs/assumptions over
  the life of the option and incorporates them into
  its implied value.
• Expected dividend yield
• Expected volatility
• Risk-free interest rate

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Expected Volatility for Both Models

• Public companies with long trading history
• Historical volatility, adjusted for
  company-specific unusual events (e.g.
  divestitures/acquisitions, unfavorable
  regulations, etc.).
• Review of exchange-traded instruments for implied
  volatility.
• OR
• Review of peer companies exchange-traded
  instruments for implied volatility.
• Public companies with brief trading history and
  Nonpublic Companies
• Review of peer companies historical
  volatilities.
• Review of peer companies exchange-traded
  instruments for implied volatility.
• Review of industry sector volatility.

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Additional Variables Used by Binomial Models

• Post-Vesting Termination Rate
• The rate at which employees are likely to be
  subject to an abbreviated option term due to
  termination of employment.
• Calculate using the number of vested employees at
  beginning of year versus at end of year.
• Suboptimal Exercise Factor
• When employees exercise their options before the
  end of the term, that behavior is considered
  suboptimal because option theory says that
  holding an option until the end of its
  contractual term provides the highest, or
  optimal, benefit.
• Suboptimal behavior is measured by analyzing the
  ratio of share price at exercise to the options
  strike price- the suboptimal exercise factor
  (SOEF). This allows the model to account for the
  effects of early exercising of options on their
  value.
• An SOEF of 2 means that exercise is expected to
  occur when the share
• price reaches 2 times the
  exercise price. A factor of 0 1 assumes that
• no suboptimal exercise will
  occur.

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Expected Term/Suboptimal Exercise Behavior

• Companies with long option grant history
• If historical option exercise data is available,
  both expected term AND suboptimal exercise
  behavior can be calculated.
• Depending on the data tracked, this may be
  available by grantee group.
• Companies with brief or no option grant history
• Vesting age forms the floor of expected term.
• The average of the vesting age and contractual
  term may be used in the absence of empirical
  data, as referenced in the Staff Accounting
  Bulletin (SAB) No. 107 (para. D.2. question 6 and
  its interpretive response) published 3/29/05.
• Expected holding periods observed by employees in
  similar industries (not widely available at
  present).

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Representative Example Newco

• Assume we have a small cap public firm, Newco,
  which was recently taken private by management
  and a private equity firm in a sponsored
  management buyout. The purchase price for the
  company was 200 million consisting of 100
  percent equity provided by the private equity
  group, the financial sponsor. In the 12 months
  preceding the buyout, Newco had 40 million in
  EBITDA (implying a 5x purchase price multiple
  valuation). Assume that on the date of the
  transaction, there were 20 million shares
  outstanding at a price of 10 per share.
  Pursuant to the transaction, the private equity
  group issued 10 percent of the equity of Newco
  (taking various forms as described in the
  following examples) to management in an effort to
  provide incentive compensation to management.
  Also assume that Newco has issued options to
  employees in the past.

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3 Scenarios Regarding the Granting of Equity
Awards to Newco Management

• Equity in the form of RSGs Management of Newco
  was issued RSGs representing 2,000,000 shares of
  the company (or 10 percent of the equity) at a
  price of 10 per share which vest in equal
  increments over the next 4 years.
• Equity in the form of Options Management was
  issued options (with a strike price of 10 per
  share) to purchase 2,222,222 shares of stock of
  Newco (or 10 percent of the equity of the company
  post dilution). These options vest in equal
  increments over the next 4 years.
• Newco management (in aggregate) issued notes to
  the company bearing a 5 percent interest rate for
  their purchase of 10 percent of the equity of the
  company. These are non-recourse notes and are
  only secured by the shares they were used to
  purchase.

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If Equity award is in the Form of RSGs Current
Rules

• Assuming a combined discount (to account for the
  lack of control and marketability associated with
  the RSGs) of 30 percent on the RSGs, the value
  per underlying share (as represented by the RSGs)
  would be 7 per share.
• The company must then recognize this cost of
  14.0 million (2,000,000 shares x 7.00/share) in
  equal installments of 3,500,000 (14.0 million
  4 years) over the next 4 years.
• Assume that Newcos expected and actual
  forfeiture rate are equal to zero.

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If Equity Award is in the Form of Options
Current Rules

• The Current Rules do not require any accounting
  for or recognition of compensation expense
  relating to the issuance of options to employees
  for private companies. Neither the grant,
  vesting, or exercise of the options gives rise to
  compensation expense. No expense for public
  companies (at their election) is recognized as
  long as the strike price of the options on the
  grant date is equal to fair value. Further,
  unlike public companies where numerous
  disclosures are required in the footnotes of the
  financial statements regarding option-based
  compensation, no mention of option-based
  compensation is required in the financial
  statements for private companies. Therefore,
  under the Current Rules, Newco is not required to
  recognize any expense relating to its issuance of
  the options to management.

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If Equity Award is in the Form of a Note
Current Rules

• Under the current rules, if equity is issued by a
  company to an employee in exchange for a
  non-recourse note (collateralized only by the
  equity it was used to purchase), and the
  principal amount of the note is equal to the fair
  value of the shares on the date of purchase,
  neither the issuance, vesting, or repayment of
  the note gives rise to compensation expense.

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If Equity Award is in the Form of RSGs New Rules

• The new rules do not affect the treatment of
  RSGs.
• Therefore, assuming the same 30 percent combined
  discount as in the previous example, the company
  must then recognize a cost of 14.0 million
  (2,000,000 shares x 7.00/share) in equal
  installments of 3,500,000 (14.0 million 4
  years) over the next 4 years.
• Again, assumes that Newcos expected and actual
  forfeiture rate are equal to zero.

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If Equity Award is in the Form of Options New
Rules

• Under New Rules, Newco will estimate option
  expense based on fair value as determined by an
  option pricing model (most commonly BSOPM
  Binomial Model).
• We have performed a valuation of the options
  using both of these models to estimate
  compensation expense. These conclusions are
  outlined on the following slides.
• Assume the following observations of Newcos
  option behavior (both of the financial asset and
  holders of the asset) were tracked when Newco was
  a publicly traded company and are still
  representative of future expectations.
• Expected Volatility (over entire option term)
  40
• SOEF 1
• Termination Rate (assume pre post vesting are
  equal) 0

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Compensation Expense Using BSOPM

• Additional Inputs
• Grant Date 6/1/05
• Expiration Date 6/1/09
• Strike Price 10/share
• Underlying Price 10/share
• Expected Dividend Yield 5
• Risk-Free Rate 4.5
• Fair Value 2.49/share
• Total Compensation Expense 5,533,333
  (2,222,222 x 2.49/share)
• Annual Compensation Expense 1,383,333
  (5,533,333 4 years)
• Underlying Price does not consider minority and
  marketability discounts.

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Compensation Expense Using Binomial Model

• Additional Inputs (not included in BSOPM)
• SOEF (assume it remains constant) 1
• Expected Volatility (year 1, 2, 3, 4,
  respectively) 40, 35, 30, 30
• Expected Dividend Yield (year 1, 2, 3, 4,
  respectively) 5, 6, 7, 8
• Expected Rick-Free Rate (year 1, 2, 3, 4,
  respectively) 4, 4.5, 5, 5.5
• Early-Expiration Date Assume same as option
  expiration
• Termination Rate 0
• Fair Value 1.86/share
• Total Compensation Expense 4,133,333
  (2,222,222 x 1.86/share)
• Annual Compensation Expense 1,033,333
  (4,133,333 4 years)

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If Equity Award is in the Form of a Note New
Rules

• This requires the use of a flexible option
  pricing model that allows for changing strike
  prices (in this case increasing) over the term of
  the option (should be equal to the term of the
  note).
• Additional Inputs (other than those used in
  Binomial)
• Strike Price Assume the strike price increases
  by the interest rate on the note each year (5 in
  this example).
• 6/1/05 10.00/share
• 6/1/06 10.50/share
• 6/1/07 11.03/share
• 6/1/08 11.58/share
• 6/1/09 12.16/share
• Fair Value 1.43/share
• Total Compensation Expense 3,177,777
  (2,222,222 x 1.43/share)
• Annual Compensation Expense 794,444
  (3,177,777 4 years)

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Comparison of Total Compensation Expense over
Years 1 4 Using Different Forms of Equity-Awards
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Bio Vincent D. Foster

• Mr. Vince Foster is a Senior Managing Director of
  Main Street Mezzanine Fund, L.P., the third in a
  series of Main Street funds he has co-founded
  since 1997. Previously, Mr. Foster was a Founder
  and Senior Managing Director of Main Street
  Equity Ventures II, LP, a private equity fund
  focused on growth-oriented companies operating in
  basic industries. Prior to founding Main Street
  Equity Ventures II, LP, Mr. Foster co-founded
  Main Street Merchant Partners, a fund which was
  the financial sponsor of Quanta Services, Inc.
  (NYSE PWR) and U.S. Concrete, Inc. (NasdaqNM
  RMIX).
• Mr. Foster currently serves as a Director of
  Quanta Services, Inc. he served as its
  non-executive Chairman from November 1997 through
  May 2002. He also serves as the non-executive
  Chairman of U.S. Concrete, Inc. In addition, Mr.
  Foster serves as an ex-officio director of Avail
  Consulting, LLC, a leading valuation and
  appraisal consulting firm, and as a Director of
  Carriage Services, Inc. (NYSE CSV), a leading
  provider of death care services and products in
  the United States and Technical Innovations, LLC,
  a manufacturer of specialty equipment used in the
  production of medical catheters.
• Prior to co-founding Main Street, Mr. Foster was
  a Partner of Andersen Worldwide and Arthur
  Andersen LLP ("Andersen"). Mr. Foster was the
  Director of Andersen's Corporate Finance and
  Mergers and Acquisitions practices for the
  Southwest United States. During his nineteen-year
  career with Andersen, Mr. Foster either
  negotiated or assisted in negotiating hundreds of
  transactions, including leveraged buy-outs,
  subordinated debt investments with warrants,
  minority equity investments, and distressed
  company financings. Mr. Foster is a graduate of
  Michigan State University and holds a law degree
  from the University of Houston Law School.
• Contact Information
• [phone]
• vdfoster_at_mainstreethouston.com
• www.mainstreethouston.com

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Bio Brent J. Dickey

• Mr. Dickey is a Senior Manager with Avail
  Consulting, LLC. with thirteen years of
  experience in financial and real estate
  valuation. He has extensive experience in the
  valuation of closely held stock, intangible
  assets and real property.
• Experience
• Mr. Dickeys work has been concentrated in the
  valuation of derivatives, intangible assets,
  closely held stock and real estate. These
  engagements were a result of mergers,
  acquisitions, estate and gift taxes and general
  corporate planning. He has extensive experience
  performing financial and economic analyses of
  real estate and operating businesses in various
  industries. This work has involved the
  qualitative and quantitative analysis of past
  performance and evaluation of prospective results
  of future operations. His experience includes
  working with the following industry areas
  technology, energy, oil and gas, real estate,
  chemical, entertainment, environmental and waste
  management, construction, manufacturing,
  distribution and financial industries.
• Affiliations
• Mr. Dickey is a candidate of the American Society
  of Appraisers (ASA) in the discipline of Business
  Valuation. He has completed all courses required
  for his ASA candidacy.
• Education
• Mr. Dickey holds a Masters of Land Economics and
  Real Estate, Texas AM University and a Bachelors
  degree in Business Administration, majoring in
  Finance from The University of Texas at Austin.
• Contact Information
• [phone]
• bdickey_at_avail-usa.com
• www.avail-usa.com

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Bio Robert M. Shuford

• Mr. Shuford is a Senior Associate with Avail
  Consulting, LLC in the Financial Advisory
  Services group. Prior to Avail, he was an intern
  with Main Street Equity Ventures.
• Experience
• Mr. Shuford has been closely involved in the
  valuation of closely held stock, performance of
  acquisition due diligence and the valuation of
  intangible assets for a number of clients. His
  experience also includes the financial and
  economic analysis of operating businesses,
  involving the qualitative and quantitative
  analysis of past performance and evaluation of
  prospective results of future performance. These
  engagements have been performed in connection
  with mergers, acquisitions, tax planning and
  reporting, litigation support, financial
  reporting and general corporate planning. His
  work has also involved the modeling of pro forma
  financial statements for roll-up type companies
  who are in acquisition mode. He has experience in
  valuing a number of companies in numerous
  industries. Further, Mr. Shuford has significant
  experience related to financial structuring and
  leasing (synthetic, leverage, capital and
  operating).
• Affiliations
• Mr. Shuford is in the process of achieving both
  his CFA charter and the American Society of
  Appraisers (ASA) designation in the discipline of
  Business Valuation.
• Education
• Mr. Shuford received a B.B.A. in Finance from
  Baylor University.
• Contact Information
• [phone]
• rshuford_at_avail-usa.com
• www.avail-usa.com