Early Exercise and the Valuation of Employee Stock Options

Posted: 1 Sep 1999  

Nalin Kulatilaka

Boston University - Department of Finance & Economics

Alan J. Marcus

Boston College - Department of Finance

Abstract

The Financial Accounting Standards Board has recently endorsed a proposal that will require firms to calculate and recognize as a cost of compensation the value of employee stock options at the time those options are granted. Conventional models such as the Black and Scholes or binomial models, however, are not well suited to deal with the issue of early exercise because the employee options are nontransferrable and therefore may be exercised early when an unconstrained investor ordinarily would sell the option. FASB suggest that employee options be valued using a pricing model with the expected time to exercise replacing the stated maturity of the option, which in fact is its maximum possible life. In this paper we propose a model of option valuation that explicitly accounts for the employee's propensity to exercise option early. In our model, early exercise is based on portfolio diversification motives. Because employee options are not tradable, the only way for employees to diversify portfolios that are heavily dependent on the fortunes of the firm is to exercise their options. Our model shows that FASB's proposal to use conventional pricing model to value options is prone to considerable error. Our major results are: (1) Employee stock options are worth much less than would be suggested by conventional models, even using expected terms as low as one-half the stated option life. (2) Employee stock option values are very sensitive to variables that do not appear in conventional stock option valuation models, such as employee risk aversion or the amount of non-option wealth held by the employee. (3) In contrast to the predictions of conventional pricing models for traded options, the values of employee stock options are likely to fall when stock volatility rises. (4) Values of employee options can be less than the so-called minimum option value" that has appeared in the accounting literature.

JEL Classification: G13, J33, M41

Suggested Citation

Kulatilaka, Nalin and Marcus, Alan J., Early Exercise and the Valuation of Employee Stock Options. Available at SSRN: https://ssrn.com/abstract=5335

Nalin Kulatilaka (Contact Author)

Boston University - Department of Finance & Economics ( email )

595 Commonwealth Avenue
Boston, MA 02215
United States
617-353-4603 (Phone)
617-353-6667 (Fax)

Alan J. Marcus

Boston College - Department of Finance ( email )

Fulton Hall
Chestnut Hill, MA 02467
United States
617-552-2767 (Phone)
617-552-0431 (Fax)

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