NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

The Value of Stock Options to Non-Executive Employees

"The value employees place on options [is] not consistent with the widely held view that employees value options at less than their Black-Scholes Valuation. Most employees value their options at a level that is higher than the Black-Scholes method implies."

In The Value of Stock Options to Non-Executive Employees (NBER Working Paper No. 11950), authors Kevin Hallock and Craig Olson empirically estimate the dollar value placed on employee stock options (ESOs) for a particular set of employees in a firm. Their analysis is based on the observation that employees will choose to hold an option for another period (a day, week, or month) if the utility of the income they would receive (stock price minus exercise price) by exercising the option immediately is less than the value of holding it and reserving the right to exercise it at a later date. Conversely, if employees exercise an option in the current period, then we know that the value of not exercising the option is less than what they gain by exercising it now and receiving an amount equal to the stock price minus the exercise price.

The authors find that the expected value to employees from continuing to hold their options after the vesting date is significantly related to a variety of individual and market characteristics. Options are held longer when the overall stock market is doing well relative to the firm's stock price or when an employee has a higher salary. The authors also find that exercise decisions are heavily influenced by unobserved employee characteristics such as risk aversion.

The authors note that the Black-Scholes model predicts that diversified investors will never exercise options prior to expiration but may sell if they seek liquidation. On the other hand, employees cannot sell their options to others and often exercise prior to expiration of the option. Hallock and Olson's estimates of the value employees place on options are not consistent with the widely held view that employees value options at less than their Black-Scholes Valuation (BSV); rather, the authors find that most employees value their options at a level that is higher than the Black-Scholes method implies.

These findings suggest that the value of the options to employees is greater than the cost of the options to the firm, because "early" exercise decisions by employees imply option costs that are less than the firm's BSV. Thus, if the firm under study were to curtail the use of options for middle managers because of the new FASB rule, for example, it might create employee dissatisfaction that, perhaps, could be offset only by paying employees more than what the firm spends on options. In this firm, these options appear to be a source of "competitive advantage." This firm, and other firms that offer ESOs, may do so precisely because their employees are overly optimistic about the firm's future.

One limitation of this study is that it focuses solely on the first exercise date for options from a grant. In about half of those decisions, less than 100 percent of the options in the grant are exercised. This implies that options from a grant are not valued equally. The authors note that we could learn more about the value of options to employees if we studied the partial/complete exercise decision of employees, and the timing of the second exercise decision, when less than 100 percent of the options were exercised on the first exercise date

-- Les Picker

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