The Valuation of Employee Stock Options - How Good is the Standard?

Abstract

This study contributes to the valuation of employee stock options (ESO) in two ways. First, a new pricing model is presented, allowing a major part of calculations to be solved in closed form. It incorporates a vesting period and independent, forced terminations of the contract. Designed with a focus on good replication of empirics, the model fits with given exercise characteristics better than earlier models. In particular, it is able to account for the correlation of the time of exercise and the stock price performance at exercise, suspected of being crucial for the option value. The impact of correlation is weak, however, whereas the average rate of cancellations turns out to play a central role. The second contribution of this paper is an examination to what extent of the current accounting standard of ESO valuation is subject to discretion and potential misspecification. Given my model is true, the standard is a good proxy. Yet, one important input for the standard valuation process is often unobservable at least for outsiders. Using my model as an example of how the accountant's belief on that input could interact with the truth, I show that there is wide latitude in the determination of prices.

Keywords: Employee stock options, Executive stock options, Barrier options, Exercise Behavior, Fair value accounting

JEL Classification: G13, J33, M41, M46, M52