Accounting and valuation of options to acquire company shares

PrintMailRate-it

published on 21 June 2023 | reading time approx. 9 minutes

 
The following article addresses an issue that we usually deal with in our service business, namely "Quantitative Advisory". Our "Quantitative Advisory" services are used whenever traditional valuation methods reach their limits and need to be supplemented, for example, with mathematical and stochastic methods and option pricing models. For further information please visit our service-specific homepage: Quantitative Advisory | Rödl & Partner (roedl.de)

The next article on "Quantitative Advisory" will appear in the October issue of M&A Dialogue on "Valuation of Earn-Outs" by Kai Schmidt and Armin Hagel.
 

If a reporting entity does not acquire all shares in the target company in the course of an M&A transaction, an acquisition of the remaining shares via options is often agreed. The question arises as to whether and based on which valuation approaches such options should be included in the IFRS financial statements of the reporting entity. The recognition and valuation depend on the specific form of the option contract. Because certain aspects are not or not clearly regulated within the IFRS, the reporting entity sometimes has room for manoeuvre with regard to accounting and the related valuation.

If a reporting entity does not acquire all shares in the target company in the course of an M&A transaction, an acquisition of the remaining shares via options is often agreed. The reporting entity may choose to enter into the following option contracts:

  • Purchased call options in the case of which the reporting entity, as the option holder, receives the right to purchase shares at a fixed price (long call)
  • Written put options in the case of which the reporting entity, as the writer, undertakes to buy shares at a specified price if the option is exercised by the option holder (short put)
  • Combinations of purchased call options and written put options with identical or different option exercise conditions

The exercise price ("strike") of the option can be either fixed or variable. If a variable price is agreed, it often corresponds to the fair value of the underlying shares at the exercise date or its formula-based approximation based on a revenue or profit indicator (e.g. EBITDA) of the target company, often in combination with a price cap and/or price floor.


Accounting for options to acquire company shares

Although option contracts for the acquisition of company shares are often concluded as part of M&A transactions, IFRS 3 does not regulate how to account for them. As with option contracts concluded outside of business combinations, the regulations of IAS 28, IAS 32, IFRS 9, IFRS 10 and IFRS 11 should therefore be applied.

 

First of all, it should be noted that option contracts for the acquisition of company shares are financial instruments within the meaning of IAS 32. If they meet the definition of a derivative within the meaning of IFRS 9, they must (subject to certain exceptions) generally be accounted for as a derivative financial asset or derivative financial liability under IFRS 9. According to some sources of specialist literature, an option to acquire company shares, for example, does not constitute a derivative within the meaning of IFRS 9 if the strike corresponds to the fair value of the underlying shares at the exercise date. This is justified by the fact that the value of such an option is zero at all times and is thus not influenced by the changes in the share value. In addition, a view is represented in the literature that options whose strike is based on the revenue or profit indicator (e.g. EBITDA) of the target company should not be classified as derivatives within the meaning of IFRS 9. This is the case, for example, if such an indicator is treated by the reporting entity consistently as a non-financial variable specific to one of the two parties to the contract.

 

Option contracts for the acquisition of company shares that are not derivatives within the meaning of IFRS 9 are generally unrecognised as pending transactions, provided they do not constitute onerous contracts within the meaning of IAS 37.

 

All other option contracts to acquire company shares are accounted for as derivatives in accordance with IFRS 9, unless one of the two exceptions listed below applies:

  1. Option contracts to acquire company shares do not have to be accounted for in accordance with IFRS 9 if they already enable the reporting entity to reap the current rewards associated with the underlying shares in a subsidiary, a joint venture or an associate, before they are exercised. The assessment of whether (joint) control or significant influence exists must be made on the basis of IFRS 10, IFRS 11 and IAS 28. If the reporting entity is already able to reap the current rewards, this leads to a situation where with the conclusion of the option contract, the parties already anticipate exercising it, and thus acquiring the shares in the company. The scope of application of IFRS 9 then does not include the option contract itself, but the non-derivative financial liability resulting from the (anticipated) exercise of the option. The IFRS does not explicitly regulate cases in which it should be assumed that a reporting entity is already able to reap the current rewards, and therefore, this should be assessed – according to the literature – on the basis of the contractual framework for the option and other agreements. For example, a fixed strike that is relatively low in relation to the underlying shares is seen as one of the indications for the existence of such ability to already reap the current rewards. By contrast, options for which the strike is not fixed at the contract start date or corresponds to the fair value of the underlying shares at the time of exercise do not substantiate the existence of said ability. The same applies to options whose strike is linked to the revenue or profit indicator (e.g. EBITDA) of the target company.
  2. Derivatives on shares in subsidiaries that meet the definition of an equity instrument of the reporting entity under IAS 32 are explicitly excluded from the scope of application of IFRS 9. This is the case if the so-called fixed-for-fixed criterion is met, namely the derivative is settled exclusively by physically delivering a fixed number of own equity instruments against payment of a fixed amount in cash or in exchange for other financial instruments. In the case of option contracts to acquire company shares, this exception can only apply if control over the target company already exists at the time the contract is concluded and the reporting entity thus acquires shares of non-controlling shareholders (so-called minority interests) that are attributable to equity.

 

In addition, it should be noted that in the case of written put options to acquire non-controlling interests that are settled by physical settlement on a gross basis, a non-derivative financial liability – a so-called "synthetic" liability – should be recognised in accordance with IAS 32. This is done under the assumption that the derivative has already been exercised or conditions attaching to it fulfilled. The term "synthetic" refers to the fact that recognised is a payment obligation that legally only arises when the derivative is exercised. The obligation to recognise a "synthetic" liability exists regardless of whether the written put option was classified as an equity or debt instrument in the first place.

 

The following table presents an overview of recognition variants that arise in the case of option contracts for company shares that are geared towards physical settlement, provided that they are derivatives within the meaning of IFRS 9. In principle, they also apply when concluding a combination of long call and short put.

 

 

 

Valuation of options to acquire company shares

If, according to an option contract, a financial asset or a financial liability should be recognised as a derivative, it should be measured at fair value both upon initial recognition and later, with changes in fair value always recognised immediately through profit or loss, as required by IFRS 9. The fair value of derivatives is determined according to IFRS 13. If quoted market prices in active markets are available for options on company shares, then, in accordance with the requirements of IFRS 13, it is these market prices that should be used primarily for determining the fair value. If, however, no price quotations are available – as is often the case with such options, the fair value should be determined on the basis of option pricing models. In connection with the valuation of options, one frequently encounters the terms "intrinsic value" and "time value" in addition to fair value:

  • The intrinsic value corresponds to the value of the payoff which the option holder would be entitled to receive in the event of the option's immediate exercise: the difference between the market value of the underlying shares and the strike. The intrinsic value cannot be negative because, unlike e.g. a forward/future, an option conveys a right and not an obligation (contigent claim). If the option holder no longer receives a payoff for the option, but would have to make an additional payment, the option expires worthless.
  • Time value represents the option holder's participation in future increases in value during the option term. It decreases continuously during the option term until the expiration date.

 

Finally, the fair value of an option is the sum of the intrinsic value and the time value. The option pricing models presented below therefore reflect the time value of an option in addition to the intrinsic value. 

 

1. Black-Scholes-Modell

The model is often applied in practice because of its ease of use. This is a single-period model with a closed-form solution. However, the standard Black-Scholes model is only applicable to simple, less complex options. For example, it can only be used for the valuation of European options. These, in contrast to American options which can also be exercised during their term, may only be exercised at the end of their term. However, if a company does not pay a dividend during the option term, this aspect is insignificant in most cases. In addition, this model assumes constant volatility. Empirical studies show, however, that implied volatility depends on whether an option has an intrinsic value or on how far it is from it ("volatility smile"). Furthermore, volatility is often path-dependent. Lower volatility is observed in the case of rising prices, and higher volatility – in the case of falling prices.


2. Binomial model

In contrast to the Black-Scholes model, the model (also called Cox-Ross-Rubenstein model) can incorporate changes in the input parameters during the option term. This is an iterative procedure in which, in the first step, a decision tree (a binomial tree) is built to model out the development of the market value of the shares underlying the option based on volatility and the risk-free rate of interest. The time steps (decision nodes) may be freely chosen. In the second step, the option value is determined recursively and condensed into a discounted expected value on the basis of the intrinsic values at the individual decision nodes. In contrast to the Black-Scholes model, American options can also be valued or volatilities that change over time can be taken into account.

 

The general rule is: The more decision nodes between the commitment and exercise dates, the more meaningful the results. However, the workload involved in the modelling of each intermediate step also increases accordingly.


3. Monte-Carlo-Simulation

Monte Carlo simulation is a stochastic method based on a large number of random experiments. Monte Carlo simulations are particularly suitable for pricing options whose value depends on several uncertainty factors. The uncertainty factors are then mapped via stochastic processes or distributions. In the case of company or share values, for example, it is assumed that they follow a geometric Brownian motion. If different parameters are simulated at the same time (e.g. revenue and costs or share price and benchmark index), it is essential to consider possible correlations.

 

4. Replication

In the case of options whose payoff profile does not correspond to that of a standard option, e.g. because the amount of the payoff is capped for a call, it is generally possible to replicate the payoff profile (replication) with various exotic options (e.g. asset-or-nothing calls, cash-or-nothing calls) and thus to value them. In principle, valuation by means of replication – if possible – is preferable to Monte Carlo simulation because it allows determining exact values. However, replication is usually more complex.

 

Input factors of option pricing models

Apart from the strike, all valuation models basically depend on the same input factors: the current price or share value of the shares underlying the option, the remaining term, the risk-free rate of interest, the expected volatility and the expected dividend:

  • The information on the current share price of listed companies can be easily obtained on the market. For non-listed companies, the share value is derived from the company value ("equity value"). It can be determined by means of a DCF-method or multiples-based valuation or on the basis of current transactions (e.g. financing rounds, secondaries). If different share classes are involved, more in-depth valuation considerations are usually necessary (e.g. extension by the "backsolve method").
  • The remaining term can be inferred from the option contract. If it is linked to a certain event, it should be estimated when such event will occur.
  • The risk-free rate of interest is derived from the yield curve of a country with an AAA rating (e.g. Germany). It is essential to ensure that the risk-free rate of interest is determined consistently with the term of the option.
  • There are two types of volatility: implied and historical. Implied volatility is derived from current option prices and reflects the fluctuation range for the return on the underlying share expected on the market. Historical volatility is derived from the historical development of the share price. It is generally determined over a period corresponding to the term of the option. For non-listed companies, peer group volatility is often used.
  • If there is no dividend protection for the option holders, the expected dividends must be included when determining the fair value.

In principle, the value of a put option on the same underlying share with the same maturity and identical strike can also be derived from the value of a call option (put-call parity).

 

The following applies to call options: The longer the remaining term, the higher the volatility and the risk-free rate of interest, and the lower the dividend yield, the higher the fair value of a call option.

 

The following applies to put options: The longer the remaining term, the higher the volatility and dividend yield, and the lower the risk-free interest rate, the higher the fair value of a put option.

 

If a non-derivative financial liability is to be recognised as part of an anticipated acquisition, it is recognised as fair value in the amount of the present value of the payment obligation resulting from the assumed exercise of the option and subsequently measured at amortised cost in accordance with IFRS 9. Present value is determined based on a market interest rate, taking into account the default risk (borrowing rate) of the reporting entity. In accordance with the requirement of IFRS 13 for short-term callable liabilities, this value may not be lower than the amount payable upon exercise of the option, discounted from the earliest date on which the amount would have to be paid. Therefore, a tendering of the maximum possible number of shares should be assumed and the discounting should be carried out from the earliest possible exercise date. Consequently, discounting is unnecessary for (American) option contracts that can be exercised at any time. The present value effect of any discounting of the liability is recognised through profit or loss. Changes in the estimated amount payable under the obligation at the option exercise date result in an adjustment to the amortised cost of the liability (using the original effective interest rate) through profit or loss.

 

If a long call is to be recognised in equity, this should be done at fair value on initial recognition. In the case of an option contract concluded in line with market conditions, this generally corresponds to the premium paid for the option. Changes in the value of the acquired call option should not be taken into account in subsequent periods at the reporting entity, as this is classified as an equity instrument.

 

If a written put option gives rise to the recognition of a non-derivative "synthetic" financial liability, it should be recognised as a fair value at the present value of the redemption amount (i.e. the option exercise price) in accordance with the requirements of IAS 32. The probability of exercise, especially taking into account contingency, is disregarded when determining the present value. Because, according to IFRS 13, discounting should be carried out from the earliest possible exercise date of the option, it does not apply to (American) option contracts that can be exercised at any time. If the number of shares to be acquired by the reporting entity is not fixed, a tendering of the maximum possible number should be assumed. IAS 32 does not explicitly specify which interest rate should be used for discounting for the period between the reporting date and the first exercise date. According to the literature, in addition to the reporting entity's borrowing rate, the target company's weighted average cost of cost capital (WACC) may also be considered. Therefore, the liability should be measured in accordance with IFRS 9. However, IFRS 9 does not provide any specific requirements for subsequent measurement. According to the view predominantly represented in the specialist literature, the valuation must be carried out at amortised cost (using the so-called effective interest method). The present value effect from the compounding of the liability is recognised through profit or loss. For changes in the estimated amount payable under the obligation, the amortised cost of the liability (using the original effective interest rate) is adjusted through profit or loss.

 

In conclusion, the accounting for and valuation of options to acquire shares in companies under IFRS is complex and should be considered on a case-by-case basis. The accounting effects often have a significant impact on the balance sheet and the income statement. Since the valuation depends on the classification and there is some room for manoeuvre here, a careful analysis of option contracts and a quantification of possible accounting effects is advisable – also in order to weigh up alternatives to make a decision.

From the newsletter

Contact

Contact Person Picture

David Klein

Senior Associate

+49 711 7819 147 43

Send inquiry

Contact Person Picture

Armin Hagel

Transactions Valuation Restructuring

Manager

+49 911 9193 2132

Send inquiry

Experts explain

 

Skip Ribbon Commands
Skip to main content
Deutschland Weltweit Search Menu