Gary Joseph | August 2022

This article was originally published by The Lawyer’s Daily (www.thelawyersdaily.ca), part of LexisNexis Canada Inc.

The valuation of employee stock options (ESOs) is not restricted to "high net worth" cases. Stock options are frequently granted as a tool for retention of valued employees or to reward employees for work and contribution to the bottom line of a corporation. When they form part of the asset pool of a separated spouse, counsel must be familiar with the treatment of and and valuation of this unique asset. A rather straightforward summary of the components of an employee stock option can be found in the Court of Appeal decision in Marinangeli v. Marinangeli, 2003 O.J. No. 2819. The court commented as follows:

[33] Options are comprised of two components, a cash component and time component. If the price at which the option can be exercised is less than the price of the underlying stock, the option has a cash value. For example, if the option gives the holder the right to purchase stock at $25 and the stock is priced at $35, the option has a cash value of $10. That is the cash component of the option. The fact that the option can be exercised to purchase stock for a particular time period at a set price, in some cases many years, also has value. That is the time component of the option and it decreases as the time for exercising the option goes by. There is an interrelationship between the two components.

This article focuses on the valuation of employee stock options and considers some of the challenges of adopting options valuations models to the unique characteristics of ESOs. We further consider some of the factors that must be assessed where the purpose of the valuation relates to estimating net family property for equalization purposes. All else being equal, the market value of ESOs (less any market value of ESOs held at the marriage date or considered excluded property) is factored into the calculating the net family property as of the separation date.

Options can be grouped into two main types: "call" and "put" options. Options confer upon the bearer a right but not an obligation to call (buy) or put (sell) an underlying asset or stock at a predetermined fixed price - known as a strike price - for a finite period of time. Call options are exercised when the underlying asset price exceeds the strike price, and vice versa in the case of put options. since options confer a right but not an obligation to purchase or sell the underlying asset, an option's value can never be less than zero.

ESOs are essentially call options, created by employers, that function as employee compensation - constituting, as they do, a contingent claim on the employer's underlying company stock. From the employer's standpoint, the growth in popularity of ESOs can be explained by the idea that ESOs can serve to align an employee's interests with those of the shareholders. By giving an employee a stake in their company's future financial success. ESOs can incentivize behaviour that will contribute to profitability - or put otherwise, to a higher company stock price. Today, among business executives and upper management, ESOs will frequently represent a major component of total employee compensation.

In order to ensure that the employee does indeed first contribute to company profitability before benefiting, ESOs generally include vesting conditions - for example, a requirement that an employee remains with the company for a specified minimum time period, or a requirement that a certain performance threshold for the stock be achieved. Once these option conditions are satisfied, an ESO is said to be "vested" and "exercisable." Once vested, employee stock option rights can be exercised to purchase the company stock at the discounted price stipulated within the ESO contract.

To estimate the price of an option (or ESO) requires the use of an option valuation model, of which there are many. In the case of ESOs, two of the most commonly used are the "binomial model" and the "Black-Scholes-Merton (BSM) model." The latter model takes its name from the economists who first published the model in 1973- namely, Fischer Black, Myron Scholes and Robert Merton. The assumed principle on which these, and most other options models, are built is the idea of a perfect market without arbitrage opportunities. Arbitrage opportunities exist where a profit can be made without assuming any risk or incurring any cost. For example, an arbitrage opportunity exists when two identical assets are selling at different prices in different markets. An arbitrage profit can be made based on the difference between selling at a high price and buying at a low price.
Essentially, to eliminate this arbitrage opportunity is to factor in the cost of an option, an amount equivalent to replicating a portfolio that hedges the risk of possible arbitrage opportunities. In effect, if an asset is trading at a higher or lower price, an option confers the right to buy at a lower price or sell at a higher price. In effect, riskless and costless arbitrage profit is eliminated, equivalent to paying for the price of an option. The main difference between the binomial and the BSM models is that the first posits a finite or countable number in the underlying asset's possible future price movements, and the second posits a constant and continuous statistical infinite distribution of future price movements in the underlying asset.

This is the first in a two-part series. Part two will delve further into these valuation models.

Gary S. Joseph is the managing partner at MacDonald & Partners LLP. A certified specialist in family law, he has been reported in over 350 family law decisions at all court levels in Ontario and Alberta. He has also appeared as counsel in the Supreme Court of Canada. He is a past family law instructor of the Ontario Bar Admission course and the winner of the 2021 OBA Award for Excellence in Family Law. Jen Capuno specializes in asset and business valuations, litigation support and forensic accounting. She practises at VFDR Inc., focusing on matrimonial disputes and damage quantification. len is accredited as a chartered professional accountant, chartered financial analyst, chartered business valuator, chartered investment manager, certified fraud examiner and certified in financial forensics.

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