The Cost of Employee Stock Options Determined to be Unallowable

Yesterday we discussed a recent decision handed down by the ASBCA (Armed Services Board of Contract Appeals) where the Board ruled that Luna Innovations employee stock option plan didn't meet the precise requirements of FAR 31.205-6(i) and therefore the costs were determined to be unallowable under Government contracts but those costs were not expressly unallowable so the Board did not sustain the Government's position regarding penalties for unallowable costs (see Government Looses Another "Expressly Unallowable" Case).

Today we will explain the Government's (and the Board's) logic concerning the unallowability of Luna's stock options as an element of employee compensation.

Although the cost of stock options are generally allowable compensation, there are significant restrictions in how the costs are calculated. Failing any of those restrictions will render the costs unallowable.

FAR 31.205-6(i) has three restrictions:

1. Any compensation which is calculated, or valued, based on changes in the price of corporate securities is unallowable.
2. Any compensation represented by dividend payments or which is calculated based on dividend payments is unallowable.
3. If a contractor pays an employee in lieu of the employee receiving or exercising a right, option, or benefit which would have been unallowable, such payments are also unallowable.

The Luna case focuses on the first of these three restrictions; changes in the price of corporate securities.

Luna calculated the value of the awarded stock options pursuant to the "Black-Scholes" method. The Black-Scholes model is a method of estimating the value of a stock option and relies upon five inputs; (i) the current stock price (ii) the exercise (strike) price, (iii) the risk-free rate of return, (iv) the term of the option, and (v) the stock price variance. Although this model gets a bit technical, the option price is a function of historical stock price volatility. Accordingly, the Government took a position that valuing stock options using the Black-Scholes model constituted compensation that is determined by changes in stock prices and therefore unallowable by the terms of FAR.

Under the Black-Scholes model, a change in Luna's share price after the valuation date of the options has no effect on the value of the employee stock options, however, the actual financial benefit to the recipient will depend on future appreciation in Luna's stock price. Because the options were issued with strike prices set equal to the current share price, if the stock does not appreciate in value, or declines in value, the benefit to the recipient is zero.

The Black-Scholes model is widely recognized model in financial economics and is explicitly referenced in FAS (Financial Accounting Standard) 123. Any contractor relying on this model to calculate the cost of employee stock options should consider whether such costs are at risk for becoming unallowable.