Use of Independent Valuation Specialists in Valuing Employee Stock Options: Evidence from IPOs

Abstract

We investigate the impact of independent valuation specialists on the downward bias of pre-initial public offering (IPO) employee stock option valuations. Undervalued estimates of a firm’s stock price underlying option grants result in stock option valuations that overstate earnings and provide employees with deep in the money options. For a sample of firms that completed IPOs between 2006 and 2016, we find that the decision to obtain an independent stock price valuation is more likely for firms with a Big 4 auditor and an audit committee accounting expert. We also find that valuations prepared by independent valuation specialists are less downward biased than those prepared by internal parties. Cross-sectional results suggest the following. First, independent valuations have a stronger effect on reducing downward valuation bias when the board is more independent, suggesting that independent boards facilitate independent valuations. Second, independent valuations have a weaker effect on reducing downward valuation bias when there is an accounting expert on the audit committee and when CEO equity ownership is greater, suggesting that audit committee accounting experts and greater CEO equity ownership offset the need for an independent valuation to reduce downward valuation bias.

Keywords: independent valuation specialists, accounting valuations, initial public offerings, stock option-based compensation, downward bias

JEL Classification: G13, G31, G32, G34, J33, M41