Value Of Employee Stock Options Research Articles

Employee Stock Option Valuation with an Early Exercise Boundary

Many companies are recognizing that the Black–Scholes formula is inappropriate for employee stock options (ESOs) and are moving toward lattice models for accounting or decision-making purposes. In the most influential of these models, the assumption is that employees exercise voluntarily when the stock price reaches a fixed multiple of the strike price, effectively introducing a “horizontal” exercise boundary into the lattice. In practice, however, employees make a trade-off between intrinsic value captured and the opportunity cost of time value forgone. The model proposed here explicitly recognizes and accounts for this reality and is intuitively appealing, easily implemented, and compliant with U.S. accounting standards.

Employee stock option valuation with repricing features

Repricing of an employee stock option refers to the practice of lowering the strike price and /or extending the maturity date of a previously granted employee stock option. Normally, firms reprice after a period of significant stock price decline that renders the employee stock options deeply out-of-the-money. By modeling various repricing mechanisms based on some form of Brownian functional of the stock price process, we investigate the impact of the embedded repricing flexibility on the market value of the employee stock options. We manage to derive analytic representation of the price functions of the repriceable options. We also construct the lattice tree type option valuation algorithms by applying the forward shooting grid technique to incorporate the path dependent feature of the Brownian functional in the repriceable option models. Our calculations show that the repricing flexibility may have varying degrees of impact on the option values and their comparative statics. The option delta (option vega) values of the repriceable options are seen to be lower (higher) than those of the vanilla options.

Valuing Multiple Employee Stock Options Issued by the Same Company

Stock options issued to employees has become a significant component of total compensation in many firms. Although option pricing technology has evolved remarkably over the years, valuing employee stock options (ESOs) still presents numerous challenges, and there is no model that is generally accepted in practice. Simply treating ESOs as if they were plain vanilla (American) stock options fails to take proper account of a number of their particular features. Along with vesting rules and the uncertainty they entail, these features include the fact that the equity of existing stockholders will be diluted when the ESOs are exercised. In that sense they resemble warrants rather than traded option contracts. Also, the fact that ESOs are issued on a regular basis means there are typically a number of outstanding ESOs with differing maturities and strike prices, which introduces interaction among them in valuation and in optimal exercise strategy. In this article, Dennis and Rendleman present a lattice technique to value ESOs that takes account of the effects of dilution and optimal exercise for a firm that has a diverse set of ESOs outstanding. Their approach increases computational efficiency substantially over the standard solution technique for a lattice model, but realistic problems still can become intractable as the number of time steps and options grows. Fortunately, the results indicate that in most cases, the effect of dilution and interaction among exercise decisions is present but relatively small.

The Effects of Employee Stock Options on Credit Ratings

ABSTRACT: This paper examines whether outstanding employee stock options (ESOs), which represent the firm’s contractual obligation to deliver shares upon ESO exercise, affect firms’ credit ratings. I hypothesize that outstanding ESOs play two information roles—(1) suggesting equity infusion, and (2) predicting share repurchases—that help credit-rating agencies evaluate the issuing company’s debt service ability. Consistent with these hypothesized roles, results indicate that the present values of expected cash proceeds and tax benefits from ESO exercise have favorable effects on credit ratings. In contrast, the present value of the expected cost of ESO-related share repurchases has an unfavorable effect on credit ratings and this unfavorable effect is more pronounced for firms with a greater tendency to repurchase shares. The after-tax fair value of outstanding ESOs, which summarizes the effects of the above three ESO-related cash flows, is negatively associated with credit ratings. Taken together, these findings are consistent with credit-rating agencies incorporating the information conveyed by outstanding ESOs regarding potential equity infusion and ESO-related repurchases in their credit risk assessments and assigning lower credit ratings to firms with greater values of outstanding ESOs.

The Relation between Corporate Governance and CEOs' Employee Stock Options*

We investigate whether corporate governance affects the use of employee stock options (ESOs) in CEOs' compensation packages. Consistent with the managerial power view, we find that firms with poorer corporate governance grant their CEOs higher values of ESOs after controlling for the economic determinants of ESO use. We show that the relation between governance strength and ESO grant values cannot be attributed to two other plausible explanations: omitted economic factors or substitution effects between corporate governance and incentive compensation. Also consistent with the managerial power view, we show that firms with poorer governance in the pre-SFAS 123R period cut back more on ESO grant values for their CEOs after the issuance of SFAS 123R which mandated ESO expensing. Our last finding is consistent with poorly governed firms taking relatively more advantage of the favorable accounting treatment for ESOs in the pre-SFAS 123R period by granting their CEOs excess ESOs, suggesting that agency problems associated with poor corporate governance contribute to excessive ESO use

Reliability Differences for Recognized Versus Disclosed Fair Values of Employee Stock Options *

Reliability Differences for Recognized Versus Disclosed Fair Values of Employee Stock Options *

A Finite Difference Model for Valuation of Employee Stock Options

Employee stock option grants are a common incentive for employees and are a key remuneration device. These options differ from ordinary options in that they cannot be traded nor hedged. Nevertheless, the work of Carpenter enables one to price these options within a Black-Scholes framework, with one additional parameter calibrated from historical data. We develop a model where the price of the grant obeys the Black-Scholes differential equation with two additional parameters: one which controls the rate at which employees forfeit unvested options, and another which controls the rate at which employees exercise vested options. We implement a finite difference scheme for computation of the option values derived from this model.

Using Auctions to Price Employee Stock Options: The Case of Zions Bancorporation ESOARS

To estimate the grant-date expense of their employee stock options (ESOs), as required under the new accounting rules (FAS 123R), companies have typically had to choose among various theoretical valuation models because there is no secondary market for ESOs. Different models, all permissible under FAS 123R, produce widely different values, raising questions about the efficacy of the new rules. We study an alternative market-based scheme, recently proposed by Zions Bancorporation, in which options are valued by means of an online auction of securities (ESOARS) that track the aggregate payments made to the reference ESOs. Zions has conducted two ESOARS auctions, under somewhat different rules (in June 2006 and May 2007). We investigate whether the auctions represent an effective, arms-length approach to the pricing of ESOs - as indicated by bidders' demand elasticity and a comparison of the auction prices to various model-based estimates. Despite legitimate concerns about size and seller incentives, we find that the auction mechanism appears quite resilient in terms of delivering fair values of ESOs. In particular, the 2007 auction - with rules that, for instance, reduce incentives to delay bidding ('snipe') - produced a value similar to those generated by models that explicitly consider the historical pattern of employees' early exercise decisions (e.g., Bajaj et. al. (2006)). Policy and other implications of our findings are discussed as well.

Employee Stock Option Valuation with Repricing Features

Repricing of an employee stock option refers to the practice of lowering the strike price and /or extending the maturity date of a previously granted employee stock option. Normally, firms reprice after a period of significant stock price decline that renders the employee stock options deeply out-of-the-money. By modeling various repricing mechanisms based on some form of Brownian functional of the stock price process, we investigate the impact of the embedded repricing flexibility on the market value of the employee stock options. We manage to derive analytic representation of the price functions of the repriceable options. We also construct the lattice tree type option valuation algorithms by applying the forward shooting grid technique to incorporate the path dependent feature of the Brownian functional in the repriceable option models. Our calculations show that the repricing flexibility may have varying degrees of impact on the option values and their comparative statics. The option delta (option vega) values of the repriceable options are seen to be lower (higher) than those of the vanilla options.

Optimal Exercise Patterns and Valuation of Employee Stock Options: An Approximate Dynamic Programming Approach

This paper develops a procedure for modeling the optimal exercise patterns and for determining the value of employee stock options. I develop an approximate dynamic programming (ADP) procedure and show how ADP can be used instead of traditional backward dynamic programming to solve the single stock option problem. I show how ADP can be extended to solve a high dimensional problem numerically that allows for a portfolio of heterogeneous options while using a CRRA utility function. I then demonstrate that the exercise of an option depends importantly on the payouts of the previous exercises.

Valuing Employee Stock Options Through Simulations

This article propose a new and flexible approach to obtain the fair value of Employee Stock Options (ESOs) plans using simulations. We adapt the algorithm of Longstaff and Schwartz (2001) to value American options in order to consider common characteristics of ESOs plans like vesting period, departure risk or voluntary early exercise. Moreover, as an example of the flexibility of the simulation approach, we show how to introduce GARCH effects of the ESO in the valuation method and compute the price bias for a hypothetical ESO.

Valuing employee stock options under SFAS 123R using the Black–Scholes–Merton and lattice model approaches

In 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standard No. 123 (revised 2004), Share-Based Payment s (SFAS 123R), requiring all entities to recognize as expense the fair value of stock options issued to employees for services provided. Because employee stock options cannot be traded publicly, their fair value must be estimated using a model, with the Black–Scholes–Merton (BSM) and lattice models being the most appropriate alternatives. This teaching note provides an overview of employee stock options, followed by a discussion of the BSM and lattice valuation models, including their application and limitations. A project which has been used in financial accounting courses is also presented. The conceptual discussion coupled with illustrated examples will help students enhance their understanding of fair value estimation of and accounting for employee stock options under the recently adopted SFAS 123R.

An IFRS 2 and FASB 123 (R) Compatible Model for the Valuation of Employee Stock Options

An IFRS 2 and FASB 123 (R) Compatible Model for the Valuation of Employee Stock Options

The Guideline Publicly Traded Company Method and the Market Value of “Invested” Capital: Should Market Value of “Stakeholder” Capital be the Appropriate Reference?

Abstract If a business appraiser ignores the value of employee stock options when calculating the market value of invested capital (MVIC) for guideline publicly traded companies, the appraiser may significantly undervalue his or her subject company, all else being equal.

ESO Compensation: The Roles of Default Risk and Over-Confidence

This paper derives a pricing model for employee stock options (ESO) that expands on Ingersoll (2002) and that includes default risk and considers employee over-confidence. Results show that the more risk-averse employees are and the more stock restrictions employees have, the smaller the value of ESOs. The model also incorporates potential subjective mis-pricing on the part of over-confident employees and finds that, under normal calibrations, employees who over-estimate firm returns by more than 5% will prefer ESOs over cash compensation. The results of this study may impact relevant accounting regulations regarding the valuation of ESOs as well as compensation decisions.

A Matrix-Based Lattice Model to Value Employee Stock Options

According to the Revised FAS Statement No. 123 issued on December 16, 2004, (FAS123R) the accounting treatment of employee stock options (ESOs) for U.S. companies will be radically different in the near future. Although, FAS 123R does not specify a particular valuation technique as preferable, it recognizes that lattice models may be better suited than closed-form models (such as variants of the Black-Scholes model) to accommodate various unique features of ESOs. In light of such recent regulatory changes, our paper makes two contributions. First, we develop a reduced form lattice-based ESO valuation model that incorporates employees' expected early exercise rule through an estimated early exercise matrix. This matrix provides the likelihood of early exercise of a vested and exercisable option at a particular node on the lattice, as a function of the ESO's remaining vested life and the option's in the moneyness at that particular node. Since our early exercise matrix is estimated from data on exercise decisions concerning past grants by the company's employees, it either directly or indirectly takes into consideration the various factors that could affect early exercise according to FAS123R. Second, our paper provides a detailed methodology of the manner in which the early exercise matrix can be estimated and our reduced form model implemented, given sufficiently detailed data. To demonstrate the manner in which the early exercise matrix can be estimated and incorporated into the valuation model, we rely on a rich ESO dataset that has hitherto never been made public. The dataset contains the complete history of all ESOs awarded by two major technology companies (henceforth referred to as Companies A and B).

Valuing Employee Stock Options: Implications for the Implementation of NZ IFRS 2+

From 2007, New Zealand firms must report the cost of granting employee stock options (ESOs). Market‐based option pricing models assume that option holders are unconstrained in their portfolio choices and thus are indifferent to the specific risk of any firm. By contrast, ESO holders are frequently required to hold portfolios that are over‐exposed to the firm that employs them and so adopt exercise policies that reflect their individual risk preferences. Applying the model of Ingersoll (2006) to hypothetical ESOs, we show that ESO cost can be extremely sensitive to employee characteristics of risk aversion and under‐diversification. This result casts doubt on the usefulness of any market‐based model for pricing ESOs, since such models, by definition, produce option values that are independent of employee characteristics. By limiting employee discretion over the choice of exercise date, vesting restrictions help reduce the magnitude of this problem.

On the Effect of Employee Stock Options on Credit Risk - A Credit Rating Agencies' Perspective

This paper empirically examines whether and how credit rating agencies incorporate the information contained in outstanding employee stock options (ESOs) when assessing the credit risk of the issuing company. I hypothesize that outstanding ESOs play two informational roles in credit risk assessments - signaling equity infusion and predicting future repurchases - that help credit rating agencies evaluate the cash flow implications at the settlement of ESO contracts. My empirical analyses show that the fair value of outstanding ESOs has a negative impact on the issuer's credit rating after controlling for information risk, operating risk, incentive effects, and other known factors that affect perceived credit risk. This adverse impact is more pronounced for companies that repurchase shares in response to ESO exercise and is robust to the control of the endogenous choices of option issuance and ESO-related repurchases. Moreover, I find that the fair value change in outstanding ESOs subsequent to the grant date is incrementally informative about credit ratings beyond the grant date fair value. Collectively, these findings are consistent with the hypothesis that credit rating agencies incorporate in their credit risk assessments the information conveyed by outstanding ESOs about potential cash outflows associated with ESO-related repurchases. I do not find, however, that the present value of the expected proceeds from option exercise is associated with credit ratings. This latter finding suggests that credit rating agencies do not attach additional valuation on ESOs' promise to create future equity beyond the information that has been reflected in the fair value of outstanding ESOs.

An IFRS 2 and FASB 123 (R) Compatible Model for the Valuation of Employee Stock Options

In this paper, we show how employee stock options can be valued under the new reporting standards IFRS 2 and FASB 123 (revised) for share-based payments. Both standards require companies to expense employee stock options at fair value. We propose a new valuation model, referred to as Enhanced American model, that complies with the new standards and produces fair values often lower than those generated by traditional models such as the Black–Scholes model or the adjusted Black–Scholes model. We also provide a sensitivity analysis of model input parameters and analyze the impact of the parameters on the fair value of the option. The valuation of employee stock options requires an accurate estimation of the exercise behavior. We show how the exercise behavior can be modeled in a binomial tree and demonstrate the relevance of the input parameters in the calibration of the model to an estimated expected life of the option.

Discretionary Reporting of Stock Options by IPO Firms

The revision of SFAS No. 123 (SFAS No. 123R, FASB 2004) requires companies to recognize the fair value of employee stock options. In addition, nonpublic companies will no longer be permitted to assume stock price volatility of zero when calculating the fair value of their stock options. This study finds that the zero volatility assumption allowed under the original version of SFAS No. 123 (FASB 1995) resulted in an average estimated fair value of options that was $1.06 (40 percent) less than the fair value calculated using a peer group volatility estimate for firms undergoing an initial public offering (IPO). However, IPO firms that estimated their volatility underreported option values by an even larger magnitude than the group using the zero volatility assumption. Perhaps these firms reported a downward-biased estimate of volatility to inhibit analysts from computing option values using more reasonable volatility estimates. Contrary to the findings for public companies, we find that a large percentage of sample firms issued in-the-money options prior to going public. Following the IPO, only a small portion of firms issued in-the-money options. The concerns regarding recognizing option expense may be less important than the benefits of granting in-the-money options for IPO firms.