The Valuation of Executive Stock Options when Executives Can Influence the Payoffs

Abstract

It is widely believed that because of liquidity constraints and vesting requirements, executives value stock options at less than market or Black-Scholes-Merton values, as would be perceived by outside investors. This belief is contingent, however, on a subtle assumption that executives are, like shareholders, price takers with no ability to influence the underlying stock. But executives clearly have the ability to influence the stock, as that is the principal reason why they are granted the options. As such, executives are likely to be more willing to hold options than would ordinary investors, an important fact not captured in conventional models. We develop a model in which executives exert costly effort to alter the stock return distribution. We find that when executives act optimally, their options are worth much more than generally believed and potentially more than the market values of the options. Thus, conventional wisdom that the cost of stock options is less than the market value of these options is not necessarily true as these options can even be worth more than Black-Scholes-Merton value. In addition, this factor changes the behavior of early exercise, leading to exercise at higher threshold prices for higher quality executives and can make shorter term options be worth more than longer term options.