A stock option which has been granted and not yet exercised is generally considered to be marital property. However, the value of a stock option that has not yet been exercised depends on the future price of the underlying stock.
In addition, a restricted stock units are also generally considered marital property.
- What are stock options?
- How are stock options valued?
- What should I know about a stock option valuation?
- Valuation of options on the stock of company that is not publically traded
- What are restricted stock units (RSUs) and how are they valued?
What are stock options?
Generally speaking there are two main types of options, ‘call’ options and ‘put’ options. Every option has a strike price (the price the underlying stock can be bought or sold at) and an expiry date (the option does not last forever). Stock options are considered derivatives because their value is derived from the value of the underlying stock, however, the owner of the stock option does not actually own any stock and is not obligated to buy or sell the actual stock.
A call option gives its owner the right to buy the stock at the exercise price. For example, assume that a person has a call option with a strike price of $20 and the stock is currently trading at $30. Assuming the person can exercise the option immediately (i.e. because stock options can restrict exercise for certain time periods), they can buy the stock at $20. If the person then immediately sells the stock they will make a profit of $10. The higher the stock price, the higher the value of the call option.
Conversely, a put option gives its owner the right to sell the stock at the exercise price. For example, assume that a person has a put option with a strike price of $50 and the stock is currently trading at $30. Again, assuming the person can exercise the option immediately, they can buy the stock at $30 and sell it at $50 and so they will make a profit of $20. In this case, the lower the stock price, the higher the value of the put option.
For most stock options the strike price is equal to the underlying stock price at the grant date. This means that, even if the option can be exercised immediately, it has no value at the date that it is granted since the strike price equals the stock price. Investors who are buying a call option are betting the stock price will increase (so that the call option will be worth something in the future) and those who are buying a put option are betting the stock price will decrease (so that the put option will be worth something in the future).
The most common type of stock options which people own are employee stock options. Companies often grant employees stock options as a form of compensation. Obviously employee stock options are call options since the company wants the employee to get a bonus if the stock price increases (not when the stock price decreases, as would be the case with a put option).
Valuation of stock options
There are two ways in which to deal with stock options when dividing matrimonial property.
- Valuation Method– A value is assigned to the stock options, and they can be included in the family property with every other asset. However, since the value of the stock options depends on the unknown future value of the underlying stock, valuation techniques such as the Black-Scholes model need to be used in order to place a value on the option.
- ‘if and when’– Under this sort of agreement, the options would not be assigned a value. Instead, each spouse would be considered the owner of a certain percentage of the options. When the stock options are exercised in the future each spouse would receive their proportionate share of any profits.The advantage of using the valuation method is that there is a clean break between the spouses and the post-valuation performance of the stock is not taken into account in the value.The advantage of the ‘if and when’ approach is that it does not necessitate a valuation, and the spouse’s proceeds will not be based on speculation but on the actual value of the options in the future (however, the spouse will benefit from actual future increases in the stock price).
The issue of valuing stock options on marriage breakdown has not received a lot of attention in the courts, however, there are several reported cases that deal with this issue. Recent case law in Ontario has favoured the valuation method, and suggested that the ‘if and when’ approach may not be appropriate given the valuation and equalization process in the Ontario Family Law Act. However, in other provinces with different processes for property division (such as Alberta and New Brunswick), the ‘if and when’ approach has been accepted by the courts in several reported cases. The choice between these two valuation methods is a legal issue and not an actuarial issue.
What should you know about stock option valuations?
There are several factors that should be taken into account in the valuation of stock options on marriage breakdown which would not necessarily be reflected with valuations for other purposes.
Vesting Restrictions – Employee stock options often have vesting restrictions which prevent the employee from exercising the option until these conditions are met. For example, the employee may not be able to exercise the option for a certain number of years, or they may be required to achieve certain performance targets. These vesting restrictions need to be taken into account in the valuation.
Income Tax – Monetary gains from stock option are considered taxable income, and so there needs to be an adjustment to the value of the stock options to reflect the income tax that will be paid on any proceeds. This is analogous to the situation with pension valuations and RRSPs; since the income from these assets will be taxed when it is received, the value needs to be adjusted so that all asset values can be fairly compared on an after-tax basis (i.e. comparing money in a chequing account to the value of stock options).
Exercise Date – An option on a stock which pays no dividends (or minimal dividends) will have the highest present value if the option is assumed to be exercised at the latest possible date (i.e. on the expiry date). However, employees often don’t wait until the expiry date to exercise their stock, and this will reduce the value of the option. In most cases, this reduction should be taken into account in the valuation.
Options on a private company
Issues arise with the valuation method if the underlying stock options are not for a publically traded company. This is because the most commonly used method, the Black-Scholes method, is based on the assumption that the stock is actively traded. We do no value these stock options.
Restricted Stock Units (RSUs)
Restricted stock units represent shares in a company that will be provided to the employee in the future if certain vesting conditions are met. Prior to vesting, the employee does not own the stock and only recieves the stock when the vesting conditions are met. For example, take an employee who is granted 100 RSUs that will be vest in 1 year if they remain an employee of the company. If the employee remains with the company, in 1 year they will recieve 100 shares of the company stock. Valuation of RSUs is simpler than the valuation of stock options since the employee simply recieves shares in the future. The simpliest way to determine the present value of the RSU is to discount the present value of the company stock for the probability of vesting and income tax.
For various reasons (including accounting issues and the decline in the stock market in recent years, leading to worthless stock options) some companies have switched from stock options to RSUs. However, in Canada, the taxation of RSUs is not as favourable as the taxation of stock options for employees since the income from RSUs is treated as employment income at the date the unit vests whereas the proceeds from stock options are taxed as capital gains when the option is exercised. As a result, both RSUs and stock options continue to be used to provide employees with stock based compensation.