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 employee stock option valuations. Undervalued stock price estimates underlying firms’ option grants produce option valuations that overstate earnings and provide employees with deep in the money options. We find independent stock price valuations are more likely for firms with a Big Four auditor and an audit committee accounting expert. Furthermore, valuations prepared by independent valuation specialists are less downward biased than those prepared internally. Cross-sectional results suggest the following. First, independent valuations have a stronger effect on reducing downward bias when the board is more independent, suggesting independent boards facilitate independent valuations. Second, independent valuations have a weaker effect on reducing downward bias when an accounting expert sits on the audit committee and when CEO equity ownership is greater, suggesting these factors 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, G32, G34, J33, M41