The Advisors' Blog

One of the issues raised by some comments on the SEC’s executive compensation disclosure rules is that the current tables mix together target and earned compensation and show values that differ from what executives actually take home as pay. For example, for stock options, awards are reported at their grant date fair value but are valuable to the executives only if the stock price increases. This Pay Governance memo gives one of the clearest descriptions I’ve seen of how the accounting value of stock options differ:s from the in-the-money compensatory value, and why that matters:

Stock option accounting rules require companies to determine the fair value of stock-based compensation awards at the date of grant, which are significant and irreversible. This requires an option-pricing model, such as the Black-Scholes-Merton (Black-Scholes) model or a lattice (Binomial) model, that factors the exercise price, stock price volatility, expected term, dividend yield, and risk-free interest rate at the time of grant to estimate an economic value of the award.
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However, this accounting value differs significantly from the in-the-money value of options, which is zero at the time of grant. This can be confusing to Compensation Committees, HR leaders, and recipients, as the grants are set and disclosed in the proxy’s Summary Compensation Table at their accounting value. In some cases, option awards expire without ever being in-the-money. However, in most cases, option grants are exercised after vesting at a higher stock price, which can yield greater in-the-money value than the accounting value.

The valuation models can affect decisions. The memo continues:

When companies grant stock options, they typically utilize the accounting value to calculate a number of options that would be equivalent to a grant of a full-value award, such as a time-based restricted stock unit (RSU). For example, if the accounting value of an option was $5 versus the stock price of $20, the company would grant four options compared to one full value award.

This creates more leverage in potential values, which has yielded significant value for many organizations as the S&P 500 has grown ~600%, a compound annual growth rate of ~14% over the 2010-to-2024 time period covered in the analysis. However, there is still a population of companies where such leverage has not paid off with the option being underwater and having zero value while an RSU would have kept some value.

While many companies have moved away from stock options, they’re still in play. Pay Governance analyzed option grants by S&P 500 companies from 2010 to 2019, finding that around 65% of the options (1,409) ended up with an in-the-money present value that was above the accounting value. The memo also delves into trends by industry.

– Liz Dunshee