The Cost of Employee Stock Options

55 Pages Posted: 1 Apr 2003  

J. Carr Bettis

Arizona State University (ASU) - Finance Department; Fathom Lab; Verus Analytics, Inc

Michael L. Lemmon

University of Utah - Department of Finance

John M. Bizjak

Texas Christian University

Date Written: March 2003

Abstract

Employee stock options (ESOs) are nontransferable and employees are generally not well diversified compared to outside shareholders. These features of ESOs imply that employee option holders may optimally exercise their options significantly early relative to what would be expected for ordinary tradable options. Consequently, accounting for the cost of granting ESOs requires understanding how long employees hold the options. We use a unique database on observed option exercise patterns to document important characteristics of exercise behavior and how early exercise affects the cost of granting ESOs. We find that employees exercise their options nearly five years prior to expiration, and that there is significant predictable cross-sectional variation in exercise behavior. For example, employees in high volatility firms exercise their options more than a year and a half earlier compared to employees in firms with low volatility. We calibrate a utility-based model of option valuation to match the observed exercise behavior, and use the model to generate estimates of the cost of granting ESOs. Our estimates indicate that the cost of the option to the firm is significantly below the value of a tradable American option with a fixed 10-year (or 7-year) expiration. Importantly, we also find the bias is not uniform. Option values computed from the American valuation model with a fixed expiration overestimate the cost of ESOs more in high volatility firms compared to low volatility firms. In addition, adjusting the expiration to reflect the expected life of the option, as recommended by the FASB, still produces systematic biases in the option valuations. The FASB adjustment overstates the cost of granting ESOs in high volatility firms and understates the costs for low volatility firms, which is perhaps one reason that many technology-oriented companies (which are likely associated with high stock-price volatility) have been the most vocal in opposing the expensing of stock options. Our research suggests that modeling the exercise behavior of employees who hold stock options and how exercise patterns vary based on different firm and individual characteristics is important in understanding and accounting for the costs of granting stock-based compensation to employees.

Keywords: Executive Compensation, Option Exercises, Employee Stock Options, Corporate Governance

JEL Classification: G30, G34, J31, J33

Suggested Citation

Bettis, J. Carr and Lemmon, Michael L. and Bizjak , John M., The Cost of Employee Stock Options (March 2003). Available at SSRN: https://ssrn.com/abstract=376440 or http://dx.doi.org/10.2139/ssrn.376440

J. Carr Bettis

Arizona State University (ASU) - Finance Department ( email )

W. P. Carey School of Business
PO Box 873906
Tempe, AZ 85287-3906
United States

Fathom Lab ( email )

16211 N. Scottsdale Rd
#A6A-628
Scottsdale, AZ 85254
United States

Verus Analytics, Inc ( email )

15210 N Scottsdale Rd
Suite 250
Scottsdale, AZ 85254
United States

Michael L. Lemmon

University of Utah - Department of Finance ( email )

David Eccles School of Business
Salt Lake City, UT 84112
United States
801-585-5210 (Phone)
801-581-7214 (Fax)

John M. Bizjak (Contact Author)

Texas Christian University ( email )

Fort Worth, TX 76129
United States
817-257-4260 (Phone)

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