SEC Frowns on Black-Scholes

Agency backs more sophisticated methods for valuing warrants.

The Securities and Exchange Commission is cracking down on companies that use the Black-Scholes formula to value complicated warrants in an effort to get them to switch to more sophisticated methods.

The problem comes when companies rely on Black-Scholes to value warrants that can be exercised early or have provisions like a down round feature that protects investors in case the company goes out to raise additional funds, says Tony Alfonso, president of BDO Valuation Advisors.

As a closed-form valuation model, Black-Scholes takes into account only the stock price, the strike price and the instrument's term, and not additional complexities, Alfonso says. "Where the SEC has come out is cautioning folks that you cannot use Black-Scholes for that," he says. "You have to use an open-form model, either a lattice model, binomial, or a Monte Carlo simulation."

Companies that use Black-Scholes for valuing such warrants may find themselves on the receiving end of a comment letter from SEC staff, Alfonso says.

A slide from a speech last December by Wayne Carnall, the chief accountant in the SEC's division of corporation finance, to the American Institute of Certified Public Accounts points to this development: "There may be multiple embedded features or the features of the bifurcated derivatives may be so complex that a Black-Scholes valuation does not consider all of the terms of the instrument. Therefore, the fair value may not be appropriately captured by simple models."

The slide goes on to note, "The staff frequently finds that errors in this area are the result of companies not carefully considering and evaluating the accounting implications of provisions of their agreement at the time they are negotiating them or when the transaction is completed."

Tom Rees, a managing director in the SEC advisory practice at FTI Consulting, says the complicated accounting rules governing this area can trip up smaller companies.

"Two or three years ago, a number of clients were not getting it right and the SEC was raising issues," Rees says. "It was a pretty big theme at the time--smaller, midsize companies, raising capital, maybe getting a little more creative in terms they were using, and not aware of the accounting provisions.

"They thought the accounting was such that these warrants would be accounted for as equity instruments, and instead they were liabilities that had to be accounted for at fair value," Rees says, adding, "The accounting rules for this are quite complex. Over time, the SEC issued more interpretive guidance that helped, but it's still a complicated topic."

Alfonso says there's no one answer as to how the value of a warrant or other instrument produced by the lattice model or another more sophisticated method will compare with the valuation using Black-Scholes. "I've seen a 100% change in value and I've seen some examples where the change in value was nominal," he says. "The reason we can't answer that definitively is that all these warrant terms are different, there's not really a homogenous deal."



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