These excerpts taken from the SOHU 10-Q filed May 11, 2009.
Share Awards to Tao Wang, Chief Executive Officer of Changyou
In January 2008, Sohu communicated to and agreed with Tao Wang, who is now the chief executive officer of Changyou, to grant him 700,000 ordinary shares and 800,000 restricted ordinary shares, in lieu of his contingent right in Beijing Fire Fox Digital
Technology Co., Ltd. (Beijing Fire Fox), which was one of Sohus subsidiaries devoting to TLBB development. The 800,000 restricted ordinary shares were subject to a four-year vesting period commencing on February 1, 2008. In addition, Tao Wang would not be entitled to participate in any distributions on Changyou shares, whether or not vested, until the earlier of Changyous completion of an initial public offering or February 2012, and in any event entitlement to distributions would be subject to vesting of the shares.
In January 2009, 700,000 Class B ordinary shares and 800,000 Class B restricted ordinary shares were issued to Tao Wang, through Prominence Investments Ltd. (Prominence), which is an entity deemed under applicable Securities and Exchange Commission (SEC) rules to be beneficially owned by Tao Wang.
In February 2009, 200,000 Class B restricted ordinary shares held by Prominence became fully vested. Effective with the vesting, the number of Class B ordinary shares held beneficially by Tao Wang increased to 900,000 shares and the number of Class B restricted ordinary shares held beneficially by Tao Wang decreased to 600,000 shares.
In March 2009, Changyou effected a ten-for-one share split that resulted in the aforementioned 900,000 Class B ordinary shares and 600,000 Class B restricted ordinary shares becoming 9,000,000 Class B ordinary shares and 6,000,000 Class B restricted ordinary shares, respectively.
Share Awards to Tao Wang, Chief Executive Officer of Changyou
In January 2008 (see Note 2, Changyou Transactions), the difference between the fair values (Incremental Fair Value), of the 700,000 ordinary shares and 800,000 restricted ordinary shares granted to Tao Wang and his contingent right in Beijing Fire Fox was
accounted for as share-based compensation under SFAS 123(R). Because the terms of the issuance of the ordinary shares and restricted ordinary shares had been approved and were communicated to and agreed with Tao Wang as of January 2, 2008, this was considered the grant date under US GAAP and, accordingly, the Incremental Fair Value was determined as of that date. The portion of the Incremental Fair Value related to the 700,000 ordinary shares, equal to $1.8 million, was recognized as share-based compensation expense in product development expenses for the three months ended March 31, 2008. As a result of the modification of the vesting terms of the 800,000 restricted ordinary shares in April 2008, the portion of the Incremental Fair Value related to those shares, equal to $7.0 million, was determined in April 2008, and was accounted for as share-based compensation over the vesting period starting from the date of the modification, following the accelerated basis of attribution. For the three months ended March 31, 2009, $0.7 million share-based compensation expenses was recognized related to the 800,000 restricted ordinary shares in product development expenses. The Incremental Fair Values were determined using the discounted cash flow method.
On March 16, 2009, the ordinary shares described above, which had been issued as 700,000 Class B ordinary shares and 800,000 Class B restricted ordinary shares, became 7,000,000 Class B ordinary shares and 8,000,000 Class B restricted ordinary shares, respectively, as a result of ten-for-one share split effected on that date (see Note 2, Changyou Transactions).
A summary of the share awards to Tao Wang as of and for the three months ended March 31, 2009 is presented below. The shares and fair value presented in the following form have been revised on a retroactive basis to give effect to the ten-for-one share split.
As of March 31, 2009, there was $3.3 million of unrecognized compensation cost related to unvested Class B restricted
ordinary shares of Changyou granted to Tao Wang.
The fair value as of the January 2008 grant date of restricted ordinary shares was determined by relying in part on a report prepared by a qualified professional appraiser. Determining the fair value of the ordinary shares of Changyou required complex and subjective judgments regarding Changyous projected financial and operating results, its unique business risks, the liquidity of its ordinary shares and its operating history and prospects at the time the grants were made.
Because at the time of the grants Changyous business was at a different stage of its product life cycle than that of the publicly-listed companies in the online game industry, it was concluded that a market comparison approach would not have been meaningful in determining the fair value of Changyou ordinary shares. As a result, Sohu and a qualified professional appraiser used the income approach/discounted cash flow method to derive the fair values. Sohu applied the discounted cash flow analysis based on Changyous projected cash flow using managements best estimate as of the respective valuation dates. The projected cash flow estimate included, among other things, an analysis of projected revenue growth, gross margins, effective tax rates, capital expenditures and working capital requirements. The income approach involves applying appropriate discount rates, based on earnings forecasts, to estimated cash flows. The assumptions Sohu used in deriving the fair value of its ordinary shares were consistent with the assumptions used in developing its online game business plan, which included no material changes in the existing political, legal, fiscal and economic conditions in China; its ability to recruit and retain competent management, key personnel and technical staff to
support its ongoing operations; and no material deviation in industry trends and market conditions from economic forecasts. These assumptions are inherently uncertain and subjective. The discount rates reflect the risks the management perceived as being associated with achieving the forecasts and are based on the estimated cost of capital for Changyou, which was derived by using the capital asset pricing model, after taking into account systemic risks and company-specific risks. The capital asset pricing model is a model for pricing securities that adds an assumed risk premium rate of return to an assumed risk-free rate of return. Using this method, Sohu determined the appropriate discount rates to be 22% as of the January 2008 valuation date.
Sohu also applied a discount for lack of marketability, or DLOM, to reflect the fact that, at the time of the grants, Changyou was a closely-held company and there was no public market for its ordinary shares. To determine the discount for lack of marketability, Sohu and a qualified professional appraiser used the Black-Scholes option pricing model. Pursuant to the Black-Scholes option pricing model, Sohu used the cost of a put option, which can be used to hedge the price change before a privately held share can be sold, as the basis to determine the discount for lack of marketability. Based on the foregoing analysis, Sohu used a DLOM of 19% to discount the value of the Changyous ordinary shares as of the January 2008. Because there was no evidence to indicate that there would be a disproportionate return between majority and noncontrolling interest shareholders, the Company did not apply a noncontrolling interest discount.