For accounting purposes, most UK-based entities need to record an expense in their books for any employee share options or awards they make. These share-based payments/compensation incentivize employees and instill a sense of ownership. Valuations for share-based compensation are essential for tax and financial reporting purposes.
Valuations performed for tax purposes within the purview of HMRC include Enterprise Management Incentives (“EMI”), Share Incentives Plans (“SIP”), Company Share Option Plans (“CSOP”) and Save-As-You-Earn (“SAYE”). These valuations are not mandatory for a business operating in the United Kingdom (“UK”). However, it can offer significant tax benefits to the company and its employees.
A company issuing shares, options or equity to its employees pursuant to HMRC schemes is required to disclose and consider Actual Market Value (“AMV”) and Unrestricted Market Value (“UMV”) in its valuation report. While UMV reflects the value with no restrictions, AMV considers adjustments for restrictions such as the size of shareholdings, restrictions on disposal, voting and distribution rights, and tag-along provisions. Generally, the AMV may be a significantly lower value than UMV.
Apart from the aforementioned schemes, high-growth companies with an exit plan also issue growth shares as an alternative. Unlike EMI and CSOP, the company does not need pre-clearance from HMRC to issue growth shares.
Section 26 of FRS 102 deals with the accounting for all share-based payment transactions. The most common share-based transactions include (but are not limited to) equity-settled share-based payment transactions and cash-settled share-based payment transactions.
Under cash-settled share-based payment transactions, the company offers future cash payment (rather than an equity instrument) based on the increase in the entity’s share price from a specified level over a specified period of time, such as share appreciation rights (“SARs”). On the contrary, an equity-settled share-based payment transaction is settled in the company’s own equity instruments, like stock options.
There are a variety of methods utilized to calculate the fair value for share-based payments under simple and complex capital structures, but Black Scholes is widely used as prescribed in the Practice Aid by AICPA. In certain conditions, other methodologies like probability-weighted expected return method (PWERM) or a combination of two or more methods (hybrid) may also be appropriate. Market-based vesting conditions linked to metrics such as achieving a certain market or performance-based criteria like a stock price milestone, require the use of sophisticated models such as Monte Carlo Simulations or the Lattice/Binomial model.
Our article on “Equity Allocation” provides insights into various nuances that go into building an option pricing model.