Employee Stock Option Exercises Research Articles

Influence of Behavioral Factors on Early Exercise of Employee Stock Option: A Literature Review

Employee Stock Option Plans (ESOPs) have gained prominence as a successful HR strategy that improves the employees’ performance and enables the company to have an economic and strategic advantage. However, the time at which employees decide to exercise their options determines the incentive that they derive from the stock options granted to them. It is one of the crucial financial decisions which can have immense implications for both employers and employees. According to the Black Scholes Model, an option's value is maximum when it is held until maturity. But most employees exercise their options early, which comes with a cost to both the employee and the company. It can be attributed to the fact that when faced with financial decisions the individuals do not always refer to complex finance models and formulas and make decisions rationally. Instead they resort to mental accounting and shortcuts leading to bounded rationality that can unconsciously impact their decision-making process. This paper explores the literature available on behavioral factors and biases that in addition to rational factors can affect the exercise of employee stock options.

Misvaluation and the corporate propensity to hold cash

This study adopts a new perspective, misvaluation, to explain corporate propensity to hold cash. We find a strong cross-sectional relationship between misvaluation and the propensity to hold cash, which can be attributed to firms' investment, cash dividends, and equity raising activities. We further show that the equity issuance channel is driven by both firm-initiated issuance activities and the exercise of employee stock options. The results are robust after controlling for endogeneity issues. Several additional robustness tests reject alternative explanations, such as precautionary motives, agency conflicts, near-term cash needs, and tax motives.

Misvaluation and the Corporate Propensity to Hold Cash

This study adopts a new perspective, misvaluation, to explain corporate propensity to hold cash. We find a strong cross-sectional relationship between misvaluation and the propensity to hold cash, which can be attributed to firms’ equity-raising activities and the exercise of employee stock options. The results are robust after controlling for endogeneity issues. Several additional robustness tests reject alternative explanations, such as precautionary motives, agency conflicts, near-term cash needs, and tax motives. Additionally, the study examines the value of cash and shows that misvaluation can increase the value of cash held by firms that are financially constrained or have greater growth opportunities.

Accrual Management and the Decision to Sell or Hold Shares Acquired from the Exercise of Employee Stock Options

ABSTRACT This study extends the employee stock option literature by examining how the timing of sales of shares acquired at exercise varies with accrual management both before and after the exercise date. We find evidence that accrual management prior to exercise is positively associated with the decision to quickly sell shares after exercise, increasing the profitability of a short-term exercise-and-sell strategy. Alternatively, we find that post-exercise accrual management is associated with executives choosing to delay selling shares, consistent with minimizing personal income taxes. Specifically, our results suggest that executives are more likely to sell immediately after satisfying the minimum (12 month) holding period for long-term capital gain treatment when they have more income-increasing accruals during the holding period. These results expand on prior research that focused on earnings management leading up to option exercise. JEL Classifications: H24; J33; M12; M21; M52. Data Availability: Data are available from the public sources cited in the text.

Employee Stock Option Exercise and Firm Cost

ABSTRACTWe develop an empirical model of employee stock option exercise that is suitable for valuation and allows for behavioral channels. We estimate exercise rates as functions of option, stock, and employee characteristics using all employee exercises at 88 public firms, 27 of them in the S&P 500. Increasing vesting frequency from annual to monthly reduces option value by 11% to 16%. Men exercise faster, reducing value by 2% to 4%, while top employees exercise slower, increasing value by 2% to 7%. Finally, we develop an analytic valuation approximation that is more accurate than methods used in practice.

Financial Reporting for Employee Stock Options: The Importance of Differentiating Compensation from Proceeds

ABSTRACT Prior research finds a negative relation between outstanding employee stock options (ESOs) and common equity risk, suggesting that outstanding ESOs share characteristics with equity rather than liabilities. We extend this research to examine whether this relation is attributable to (1) the expected value of the cash proceeds to be received upon ESO exercise (“ESO-Proceeds”), or (2) the expected value of compensation to be paid to ESO holders for services provided (“ESO-Compensation”). This distinction is important because the question of whether outstanding ESOs share characteristics with liabilities or equity inherently pertains to ESO-Compensation, not ESO-Proceeds. Our findings indicate that the negative relation observed in prior research is attributable to ESO-Proceeds rather than ESO-Compensation, which is inconsistent with ESOs possessing characteristics of equity. Our study illustrates the importance of differentiating ESO-Compensation from ESO-Proceeds when addressing financial reporting questions related to outstanding ESOs.

Uncertainty avoidance and the timing of employee stock option exercise

We examine the impact of the cultural norm of uncertainty avoidance on employee stock option (ESO) exercise behavior using proprietary data from a multinational firm. We find that employees from countries with higher levels of uncertainty avoidance exercise their stock options earlier. These findings lend support to a maintained assumption in the ESO literature that employee attitudes toward uncertainty influence stock option exercise behaviors. Our findings further help to explain prior findings of cross-cultural differences in firms’ compensation practices by indicating that employee responses to option-based pay and firms’ consequent financial reporting costs vary as functions of employee uncertainty avoidance.

Valuing Employee Stock Options with Exogenous and Endogenous Early Exercise

This paper examines how forfeiture, vesting, and early exercise affect the value of employee stock options. The forfeiture and exogenous exercise of the options are modeled as two Poisson processes with constant intensity. Rational exercise by the employee due to the option's American feature is modeled as endogenous exercise. The Crank-Nicholson numerical method is used to solve for the resulting value of employee stock options. Results are consistent with the findings that the employee stock options are worth substantially less than the Black-Scholes formula value. The model demonstrates that the option holder would rationally exercise the option early even when the underlying stock pays no dividend. The model also provides results on the expected time to exercise of employee stock options and the expected exercise price relative to strike price. The method used in this paper is proposed as an alternative to the Black-Scholes formula for measuring fair market value of employee stock options for accounting and regulation purposes.

Risk, ambiguity, and the exercise of employee stock options

We investigate the importance of ambiguity, or Knightian uncertainty, in executives’ stock option exercise decisions. We develop an empirical estimate of ambiguity and include it in regression models alongside the traditional measure of risk, equity volatility. We show that each variable has a significant effect on the timing of option exercises, with volatility causing executives to hold options longer to preserve option value, and ambiguity increasing the tendency for executives to exercise early.

Risk, Ambiguity, and the Exercise of Employee Stock Options

We investigate the importance of ambiguity, or Knightian uncertainty, in executives’ decisions about when to exercise stock options. We develop an empirical estimate of ambiguity and include it in regression models alongside the more traditional measure of risk, equity volatility. We show that each variable has a statistically significant effect on the timing of option exercises, with volatility causing executives to hold their options longer in order to preserve remaining option value, and ambiguity increasing the tendency for executives to exercise early in response to risk aversion.

Investor Experience and Attention: The Effect of Financial Shocks on Individual Trading Decisions

Using unique data on employee ownership plans sponsored by U.S. public companies, we estimate the effects of the 2008 financial crisis on individual investors’ participation and trading decisions. Consistent with a decreased willingness to take risk, we observe an increase in the average propensity to exercise employee stock options following the crisis, controlling for grant timing and moneyness in addition to time-invariant firm and employee characteristics. However, the results are concentrated among employees with limited experience in option plans prior to the pre-crisis run-up in equity prices. Moreover, we find that low-experience employees also increase their participation in employee stock purchase plans (ESPPs) following the shock. Conditional on initiating participation in ESPPs, we find that they are disproportionally likely to sell the acquired shares both immediately and within the first year of ownership. Since declining to participate in an ESPP amounts to leaving money on the table, our results suggest a new wrinkle in our understanding of how investors’ personal return experiences interact with risk preferences. While negative shocks appear to diminish investors’ appetites for risk, they also mitigate investor inattention. Thus, at least along certain dimensions, they can induce investors to make decisions that are closer to the optimum.

Are employee stock option exercise decisions better explained through the prospect theory?

In this paper, we introduce a new framework for the analysis of employee stock options exercise decisions. We develop a distorted lattice model where the exercise decision obeys a policy that maximizes the expected value of the exercise outcomes under the Cumulative Prospect Theory. Using a large US dataset of exercise transactions, we show that our framework broadly outperforms the Expected Utility Theory framework in explaining empirical exercise decisions. Interestingly, our empirical estimates of probability weighting are consistent with those from the experimental literature. We argue that this analysis provides a unifying stream for thinking about issues related to the exercise and the valuation of stock options.

National Culture and the Timing of Employee Stock Option Exercise

We explore the impact of cultural norms on employee stock option (ESO) exercise behavior using proprietary data from a multinational firm. We find that employees in countries where there is a greater cultural norm to avoid uncertainty exercise their stock options earlier. Our results suggest that both an employee’s valuation of option-based pay and a firm’s financial reporting cost to compensating employees with options should vary predictably across countries. Our findings provide insight into the use and effectiveness of option-based compensation for international employees.

Employee stock option-implied risk attitude under Rank-Dependent Expected Utility

Probability weighting is one of the cornerstones of decision-making theories accommodating gambling preferences. This paper examines its relevance to explaining employee stock option exercise behavior. We characterized the optimal exercise policy for a representative employee with Rank-Dependent Expected Utility (RDEU) preferences. We find that the RDEU framework leads to improved predictions of empirical exercise patterns. The implications from our findings are twofold: (1) probability weighting implies an increase in stock option cost to shareholders; (2) employee exercise behavior-implied sentiment is affected by the firm's stock market risk and performance.

A Model of Equity Based Compensation with Tax

In this paper, we develop a two-stage continuous time model of employee stock option (ESO) valuation under different tax regimes. We show that tax rules can have significant effects on ESO exercise behavior. In addition, we find that incentive stock options (ISO) are the optimal form of compensation for all levels of employees in the UK. In the US, restricted stock plans are preferred, and tax breaks offered by incentive schemes are only beneficial to employees with high liquid wealth (or small option holdings relative to wealth) or low risk aversion. We also analyze 83b elections for restricted stock plans in the US and find that making an election is a sub-optimal decision for both the employee and the firm.

Share Repurchasing and the Policies of Stock-Options

The objective of this paper is to examine the relation between share repurchases and stock options. In fact, certain studies demonstrate that the development of stock option plans since the beginning of the 1990s is also considered one explanation for the increase in equity programs for repurchasing shares. We have tested the validity of our hypothesis on a sample of 77 French firms listed during the 2003-2008 period. The results demonstrate a positive link between the performance of near future exercise of employee stock options and share repurchases. The desire to avoid the dilution associated with the performance of stock options can thus be one of the motives for making share repurchases. The results subsequently demonstrate that directors holding a substantial number of stock options encourage companies to make share repurchases. On the other hand, we detected a negative relationship between the existence of managerial stock options and the augmentation of dividends.

Diluted Earnings Per Share Overstatement Bias: Including Unrecognized Employee Compensation In Proceeds From Assumed Exercise Of Employee Stock Options Under The Treasury Stock Method

Generally accepted accounting principles (GAAP) require firms to recognize compensation expense under the fair value method in the case of employee stock options. Straight line amortization of the options grant date fair value must be recognized as expense over the service period which decreases the earnings per share numerator. For diluted earnings per share (EPS), GAAP requires using the treasury stock method, where proceeds from assumed stock option exercise is used to purchase treasury shares at the average for the period price. Exercise proceeds include the exercise price plus unrecognized future employee compensation. For profitable firms, exercise is assumed if dilutive - more shares are assumed issued than are reacquired for the treasury which increases the diluted EPS denominator. These requirements are consistent across US GAAP and International Financial Reporting Standards. This paper tests whether including unrecognized employee compensation in proceeds from the assumed exercise of employee stock options under the treasury stock method is appropriate. A simple multi period model that assumes a risk free environment with complete certainty is applied. This study contributes to the literature by demonstrating that future unrecognized employee compensation should not be included in proceeds from the assumed exercise of stock options under the treasury stock method. Doing so consistently causes diluted EPS overstatement, and in certain instances causes assumed exercise of in the money options to be antidilutive, which results in complete exclusion from the diluted EPS calculation. This research extends the employee stock option work of Doran (2005 and 2008) that found: 1) Compensation expense recognized over the employee service period should equal the periodic annuity amount that provides the options grant date fair value, and 2) Treasury shares should be assumed purchased at the higher end of period stock price.

Non-marketability and the value of employee stock options

We adapt the Benninga et al. (2005) framework to value employee stock options (ESOs). The model quantifies non-diversification effects, is computationally simple, and provides an endogenous explanation of ESO early-exercise. Using a proprietary dataset of ESO exercise events we measure the non-marketability ESO discount. We find that the ESO value on the grant date is approximately 45% of a similar plain vanilla Black–Scholes value. The model is aligned with empirical findings of ESOs, gives an exercise boundary of ESOs and can serve as an approximation to the fair value estimation of share-based employee and executive compensation. Using the model we give a numerical measure of non-diversification in an imperfect market.

Nonmarketability and the Value of Employee Stock Options

We adapt the Benninga-Helmantel-Sarig (2005) framework to value employee stock options (ESOs). The model quantifies non-diversification effects, is computationally simple, and provides an endogenous explanation of ESO early-exercise. Using a proprietary dataset of ESO exercise events we measure the non-marketability ESO discount. We find that the ESO value on the grant date is approximately 45% of a similar plain vanilla Black-Scholes value. The model is aligned with empirical findings of ESOs, gives an exercise boundary of ESOs and can serve as an approximation to the fair value estimation of share-based employee and executive compensation. Using the model we give a numerical measure of non-diversification in an imperfect market.

The Impact of Tax Incentives on the Choice to Hold Shares Acquired from Employee Stock Option Exercises

ABSTRACT This paper extends prior stock option literature by examining the impact of individual and corporate tax incentives on the decision to hold or sell shares acquired through the exercises of incentive stock options (ISOs) and non-qualified stock options (NQSOs). We focus on factors found in prior literature to be associated with the choice to hold or sell in the context of the type of stock option exercised. Specifically, we find that the positive (negative) relation found in prior literature between the decision to hold shares following exercise and future returns (depth) is associated more with NQSOs than ISOs, consistent with individual tax incentives. Examining corporate tax incentives, we find that corporate tax benefits mitigate insiders' likelihood to hold shares obtained from ISO exercise. Furthermore, we find evidence that firms compensate employees to forgo individual tax benefits associated with holding shares from ISO exercise, and as this compensation increases, insiders are more likely to sell following exercise. JEL Classifications: H24; H25; J33.