Equity-based Compensation For S Corporations Barry Goodman CFA , ASA, CPA/ABV, CBA, CFP

1. Equity-based Compensation For S Corporations Barry Goodman CFA, ASA, CPA/ABV, CBA, CFP Advanced Valuation Analytics, Ltd.

2. Authority For Valuing Options • Statement of financial standards no. 123. • Issued in October, 1995. • Assume fair value for accounting purposes.

3. Two Methods Used To Value Stock Options • Black - Scholes model • Binomial model

4. General Factors Used To Value Options • Price of the underlying stock • Adjustment for dividends • Exercise price • Risk-free rate of return • Expected life of the options • Volatility of the underlying stock

5. Price of the Stock • What about the esop stock price? • Adjustment for marketability.

6. Adjustment for Dividends • Dividends not received until options exercised. • Generally considered to be the present value of the dividends to be paid through the expected life of the dividend. • Can be hard to estimate.

7. Risk-free Rate of Return • FAS 13, paragraph 19: • “For options that a U.S. entity grants on its own stock, the risk-free interest rate used shall be the rate currently available on zero-coupon U.S. government issues with a remaining term equal to the expected life of the options.”

8. Expected Life of the Options • This is very subjective. FAS 13 includes the following factors to consider: • The vesting period of the grant. The expected life must at least include the vesting period. In addition, if all other factors are equal, the length of time employees hold options after they first become exercisable may vary inversely with the length of the vesting period. For example, employees may be more likely to exercise options shortly after the options vest if the vesting period is four years than if the vesting period is only two years. • The average length of time similar grants have remained outstanding in the past. • Expected volatility of the underlying stock. On average, employees may tend to exercise options on highly volatile stocks earlier than on stocks with low volatility.

9. Volatility • In general, high volatility will result in a higher value of an option. • For non-public companies, no volatility factor is used.

10. Effect of Plans on Value of Stock • Based upon FAS 123, an expense is measured pursuant to the stock-based compensation. • An expense reduces operating income, ebit, and ebitda. • An expense does not always reduce operating cash flow unless the estimation of cash flow is based on ebitda.

11. Stock Options-Dilution • When the option is granted, assuming that the exercise price is equal to the stock price, there should be no dilution. • Additional shares that could be issued are considered, but: • The value should be increased by the capital contribution to be received by the company upon the exercise of the options. • There is potential dilution if and when stock price increases from the date of the grant.

12. Stock Option Expense • Does not directly affect cash flow. • Does threaten dilution in the future. • What adjustment might be made to ebitda and/or operating cash flow for valuation purposes? • Is the expense level in any one year considered to be non-recurring or unusual in amount?

13. Phantom Stock and SARs • Both are cash-based compensation that will ultimately result in a reduction of operating cash flow. • Unless the amounts are judged by the appraiser to be non-recurring and/or unusual, EBITDA and cash flow will be reduced for valuation purposes.

14. Restricted Stock • Does not directly affect cash flow. • It is dilutive and will therefore negatively impact on the value per share.