Chapter 16: Employee Stock Options

Contractual Arrangements

Employee stock options (ESOs) are call options granted to employees as compensation. They differ from exchange-traded options in important ways:

Do Options Align Interests?

Arguments for ESOs:

• Align employee interests with shareholders
• Attract and retain talent
• Provide incentives without using cash (important for startups)

Arguments against:

• Executives may take excessive risk (option convexity rewards volatility)
• Executives may time information disclosure to maximize option value
• Options create diluted earnings per share
• Repricing underwater options undermines incentive effects

Accounting Issues

Under FASB and IASB rules, companies must expense ESOs at fair value on the grant date. This reduces reported earnings.

Fair value is estimated using option pricing models, with adjustments for:

• Expected life (shorter than contractual life due to early exercise)
• Forfeiture rates
• Non-transferability

The typical approach uses the Black–Scholes–Merton with the expected life replacing contractual life as $T$. An alternative is to use a binomial tree that explicitly models early exercise behavior.

Valuation

ESO valuation is complex because employees exercise early for several reasons:

1. Diversification: Employees can't diversify away company-specific risk
2. Liquidity needs: Employees need cash
3. Employment termination: Options may expire soon after leaving

A common model: employees exercise when the stock price reaches a multiple $M$ of the strike price (e.g., $M=2$ in Hull–White model). The ESO value can be computed using binomial trees with this early exercise rule.

Key result: ESOs are worth less than comparable regular American call options because of:

• Vesting periods
• Early exercise behavior (employees don't optimize exercise the way option traders would)
• Forfeiture risk

Typical ESO value is 30-50% of the Black–Scholes–Merton value for the same parameters.

The Backdating Scandal

In the mid-2000s, over 100 companies were found to have backdated option grants — they chose a grant date when the stock price was low to give recipients a lower (more favorable) strike price. If the date was fabricated, it constituted fraud.

Consequences included:

• Restated earnings (options were granted in-the-money but treated as at-the-money)
• Executive resignations
• SEC investigations and fines
• Criminal charges in the most egregious cases

The scandal led to stricter documentation requirements: companies must report option grants within two business days.