How to value ZEPOs in private companies for financial reporting?
What are ZEPOs?
ZEPOS are a type of call option issued under an Employee Share Scheme.
A call option provides the owner the right (but not the obligation) to purchase an underlying asset at a fixed price (the Exercise Price) within a specific timeframe (Expiration Date).
ZEPOs are call options with a zero exercise price. Consequently, once the options vest (become exercisable), employees can exercise the options and acquire the company shares at zero cost.
Recognising ZEPOs for financial reporting
Per the Accounting Standards (AASB 2) a company measures any increase in equity at the Fair Value of the services received. Unless the fair value of the services cannot be estimated reliably.
Where a company cannot estimate reliably the fair value of the services received, the entity measures the fair value of the ZEPOs granted (Paragraph 10). The fair value is based on observed market prices for the same or similar ZEPOs (Paragraph 16).
However, typically for private companies, a market for ZEPOs does not exist. In this situation, per the standards, the fair value of the ZEPOs granted are estimated by applying an option pricing model (Paragraph B4).
Option models involve assessing the following key inputs: share price, exercise price, volatility, expiration date, risk-free rate and dividend rate.
Intrinsic value of ZEPOs
Per AASB 2, Intrinsic Value is defined as (Appendix A): “the difference between the Fair Value of the shares to which the counterparty has the right to subscribe and the price (if any) the counterparty has to pay.” Consequently, the intrinsic Value of a call option depends on:
- Share price. If the share price goes up, the value of the call option goes up.
- The Exercise price. The lower the exercise price, the higher the value of the call option.
As ZEPOs have no exercise price, the Intrinsic Value of the ZEPOs is simply the share price at the date of grant..
Impact of volatility and expiration date on ZEPOs
Prior to the expiration period of the call option, the value of the call option is equal to the risk-adjusted share price less the risk-adjusted present value of the exercise price.
The value of a call option depends on the probability that the underlying share price will be greater than the exercise price. The factors that influence the probability that the share price will be greater than the exercise price include the:
- Share price volatility: the higher the level of share price volatility, the higher the probability that the share price will go up and the higher the value of the call option.
- Expiration date: the longer the expiration date, the higher the chance the share price can go up, and so the higher the value of the call option.
Given that ZEPOs have a zero exercise price, it is guaranteed that the share price will be greater than or equal to the exercise price. The share price and the value of the ZEPO are the same.
If the share price increases in the future, the value of the ZEPO increases by the same amount. Consequently, share price volatility and expiration date have no influence on the probability that the share price will be greater than the exercise price.
Share price volatility and expiration date do not impact the value of ZEPOs.
Impact of interest rates on the value of ZEPOs
An option allows an owner to delay purchasing the underlying shares. That delay provides the owner the opportunity to earn interest on the amount that would otherwise have been invested in the shares.
The interest rate used is the rate that is guaranteed without any risk; this is the risk-free rate. The higher the risk-free rate, the more money that can be saved by delaying the exercise of an option and the purchase of the share. The higher the risk-free rate, the higher the value of the call option.
As the cost of acquiring the underlying shares under the ZEPOs is zero, there is no interest rate saving. Interest rates have no impact on the price of ZEPOs.
Impact of dividend on the value of ZEPOs
If a dividend is paid, it removes cash from the company and the share price decreases. Consequently, if dividends are issued the value of any unvested ZEPOs decrease.
Per AASB 2, when the Fair Value of an option is estimated, expected dividends are to be included in the option pricing model. The value of the ZEPO is reduced by the present value of dividends expected to be paid during the vesting period.
Dividends impact the value of ZEPOs. The impact will depend on the vesting date, the expected future earnings and expected future dividend distribution rate to the vesting date and the discount rate.
Impact of ZEPO vesting conditions
ZEPOS are typically issued under a company share incentive plan. The plan sets out the rules for exercising options, together with any conditions for the vesting and exercise of options.
A common vesting condition is a Service Condition, for example, that an employee provides services for a specified period. Other conditions can include Performance Conditions and Market Conditions:
- A Performance Condition requires both a specified period of services and a specified performance target to be met.
- A Market Condition is a Performance Condition where the performance target relates to the market price or value of the equity instrument.
Per AASB 2, Performance Conditions are reflected in the Fair Value at the grant date. Service and Market Conditions are not reflected in the value of the ZEPOs.
Service and Market Conditions are instead reflected in the number of ZEPOs expected to be issued at each vesting date. For example, the further a vesting date is in to the future, then the less likely an employee may still be employed and so the less likely the respective ZEPOs would vest. A company revises the likely number of ZEPOs to vest at each financial year, based on the liklihood of meeting service performance conditions at that reporting date.
Market Conditions are reflected in the fair value of the ZEPOs at the date of grant. The value incorporates the probability of meeting the performance target. This requires modelling potential outcomes.
Summary
AASB 2 requires the application of an option model to value ZEPOs which require disclosing inputs such as volatility and the risk free-rate. However, given that ZEPOs have a zero exercise price, the only option model inputs that impacts value are the share price and the present value of future expected dividends.
