How to Value Employee Stock Options

Abstract

One of the arguments often used against expensing employee stock options is that calculating their fair value at the time they are granted is very difficult. This article presents an approach to calculating the value of employee stock options that is practical, easy to implement, and theoretically sound. It explicitly considers the vesting period, the possibility that employees will leave the company during the life of the option, the inability of employees to trade their options, and the relevant dilution issues. This approach is an enhancement of the approach suggested by the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 123 because it does not require an arbitrary reduction in the life of the option to allow for early exercise caused by the inability of employees to trade their options.

The issue of whether companies should be required to expense employee stock options has received a great deal of attention in recent years. In October 1995, the Financial Accounting Standards Board published Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation. This statement encourages companies to expense employee stock options, but it does not require them to do so. Immediately following the publication of FAS 123, few companies opted to expense stock options. Recently, however, a marked increase has taken place in the number of companies doing so, and in all likelihood, the International Accounting Standards Board and a number of national accounting boards will require expensing in the near future.

One of the arguments often used against expensing employee stock options is that calculating their fair value at the time they are granted is very difficult. We present an approach to calculating the value of employee stock options that is practical, easy to implement, and theoretically sound. It explicitly considers the features of executive stock options that make them different from regular options. These features are (1) the vesting period, (2) the possibility that employees will leave the company at some time during the life of the option, (3) the inability of employees to trade their options, and (4) the potential dilution.

Our approach is an enhancement of the approach suggested by FAS 123 in that our approach does not require an arbitrary reduction in the life of the option to allow for early exercise caused by the inability of employees to trade their options. Instead, our approach assumes that the option is exercised when the stock price reaches a certain multiple of the exercise price. This multiple, called “the early exercise multiple,” is determined empirically. In addition to the parameters usually required to value an option, the enhanced FAS 123 model requires the vesting period, the early exercise multiple, and the average employee turnover rate (both pre- and postvesting).

In the valuation approach, the analyst may use a binomial or trinomial tree similar to that used for valuing American-style options. The calculation of the value of the option at each node is different from the calculation used in valuing a regular American option because of the following aspects:

• The enhanced FAS 123 approach does not test for early exercise during the vesting period.

• The option is assumed to be exercised when the ratio of the stock price to the exercise price reaches the early exercise multiple.

• The “roll back” calculations account for the possibility that part of the value may be lost when the employee, voluntarily or involuntarily, leaves the company.

The issue of dilution causes a great deal of confusion in the valuation of executive stock options. We show that the stock price used when an employee stock option is valued should be the price immediately after the news reaches the market that the options have been granted. When this stock price is used, no further adjustment for dilution is necessary. The impact of dilution is already reflected in the stock price.

The authors are grateful to the Ontario Teachers' Pension Plan for funding this research.