The impact of share-based payments on financial performance and valuation considerations

The issue of equity in lieu of cash payments for services, as part of bonus remuneration structures or as part of satisfying all or part of the purchase consideration of an acquisition is becoming more and more common with private and public companies. As small private companies are not required to comply with the Australian Accounting Standards Board (AASB) Standards, this written piece focuses primarily on the implication of Share-based Payments to public companies, however, private companies should also consider the implications.

The immediate advantage to the issuer, the company, is that it can retain the services of consultants, advisers, employees, executives or fund acquisitions on a non-cash basis via the issue of equity such as shares, options or performance rights. However, there are also disadvantages to using equity in this manner such as the dilution impact to existing shareholders and financial reporting impact.

AASB 2 Share-based Payments requires a company to reflect the effects of Share-based Payments in its financial statements. A Share-based Payment transaction is required to be valued at fair value and expensed over the benefit period in the financial statements and may thus impact any future or forecast reporting periods. The resultant expense amount and any negative impact to current or future earnings, if not properly considered at the time of issue, may surprise the company and its shareholders. Proper consideration of the issue and assessment of any unintended impact on the financial performance of the company should be undertaken at the time of issue. In some instances, Share-based Payments may require shareholder approval under ASX Listing Rules and/or the Corporations Act which may delay a particular transaction and add to costs.

Although the equity issue of ordinary shares can be straightforward to value, the issue of options and performance rights are often complex and the terms and conditions of these securities need to be reviewed and properly understood in order to avoid an incorrect valuation approach being adopted. For example, AASB 2 does not mandate the use of a particular model when valuing options and performance rights. The most commonly used and known option valuation model is the Black-Scholes model. This model is not always the most appropriate model, in particular when valuing employee Share-based Payments. A key assumption in valuing employee Share-based Payments is whether the holder will exercise the option early, if in the money, to be able to convert the option to an ordinary share and liquidate those shares for cash. The Black-Scholes model assumes the exercise of an option will occur on its expiry date which results in the greatest time value of money component being attributed to the overall value and overvaluing the Share-based Payment expense.

Understanding the valuation impact of Share-based Payments before they are issued or agreed as part of a transaction is an important consideration before entering into a binding agreement regarding the terms of any equity issued in lieu of cash payments.

PKF Corporate Finance prepare valuation advice with respect to Share-based Payments for valuation advisory, financial reporting and shareholder approval purposes. We would be pleased to assist with your requirements in understanding and quantifying the impact of Share-based Payments.