Employee stock option basics
Executive Summary Employee stock options ESOs are often used to compensate employees other than top executives; however, ESOs are complex and not well understood by employees.
In a study of ESO recipients from employee stock option basics companies, we found employees often value their own options based on simple mental shortcuts, or anchors, that make subjectively judging value easy, but they typically misestimate the true value of ESOs. Options are exercised in the future, so a judgment that incorporates the time value of money leads to higher quality, and often higher employee stock option basics, estimates of their value.
In an experiment using graduate business students who value hypothetical ESOs, we demonstrate that the type of training provided to employees matters. Companies that invest in ESO education programs will benefit from more efficient and effective use of ESOs as part of compensation packages in recruiting, retaining, and motivating employees. Financial planners can help both their clients who receive ESOs and the companies that issue ESOs to understand the underlying components of an option-pricing estimate.
She earned her Ph. She was the manager of corporate financial reporting for Gannett Co. Her research investigates how investors and analysts use financial information. Previously, she was a systems consultant working on the design and implementation of customized client information systems used in forecasting and planning.
Many companies use employee stock options ESOs to attract, retain, and motivate their employees Elson At one time, ESOs were considered too employee stock option basics a form of pay employee stock option basics rank-and-file employees, and grants were usually limited to the CEO and other C-Suite executives. More recently, the use of ESOs has spread to employee compensation packages at many levels within companies. Some question whether companies truly benefit from granting ESOs because of the complications involved in valuing them Reilly et al.
Others make their opinions quite clear: Consistent with this prediction, results of the Farrell et al. However, the study also showed that by applying particular training methods, companies can encourage their employees to apply more sophisticated techniques to value their ESOs and, by doing so, can significantly increase the value employees see in their ESOs.
A stock option is a right to buy a share of company stock for an exercise price also referred to as a strike price that extends for a period into the future the employee stock option basics periodbut then expires employee stock option basics expiration date. If the stock price increases during the exercise period, the option increases in value. A person buys an option from a seller, who agrees to sell the stock to the buyer for the exercise price if and when the buyer chooses to exercise the option.
At the point employee stock option basics the option holder decides it is advantageous to exercise the in-the-money option who would exercise an underwater option? Alternatively, the option employee stock option basics can trade the option in one of many exchanges, or can let it expire without exercising it Broadie and Detemple, Valuing financial instruments that derive their value from the change in price of the employee stock option basics asset that is, derivatives is a complex task.
A sophisticated model, employee stock option basics Black-Scholes option-pricing model, was developed to mathematically show how option values are affected by the exercise price, the underlying stock price, the extent to which that stock price changes over time volatilitythe time remaining until the option expires, and market risk-free interest rates.
For a discussion and employee stock option basics of the Black-Scholes model, see Hill and Employee stock option basics, Further complicating option valuation is the tax treatment of the gain or loss on the exercise, which depends on many factors and is beyond the scope of this article.
Hence, ESOs are often included as part of employee compensation packages. When ESOs are granted to employees, the exercise periods may be five to 10 years rather than the frequently shorter terms of tradeable optionsand the employee usually cannot exercise the option until a certain time employee stock option basics passed the vesting period. Employees who receive stock options as part of their compensation packages must place a value on those options to calculate their total compensation.
It is a challenge for employees to understand how much a stock option is worth because of the many factors employee stock option basics affect stock option value. When faced with complex mental tasks, people often reduce the effort involved by ignoring potentially important pieces of information.
Specifically, they often reduce the number of pieces of information considered and the steps to process that information and, instead, rely on simple anchor values Tversky and Kahneman, In the case of employee stock options, this means some employees may simply assign a zero value to the option until the option vests, or if the option is underwater.
Other employees may estimate ESO value at the in-the-money, or intrinsic, value current stock price less the exercise price. Finally, others may estimate the option value to be equal to the current market price of the underlying stock.
Although simple and not challenging to compute, these estimates underweight or disregard the stock price volatility, time to expiration of the option, and risk-free interest rate components of ESO value.
The use of simple anchors may lead to biased valuations, which in turn, reduce the incentive effects of ESOs and result in an inefficient use of ESO compensation by companies see Table 1. When employees misestimate the value of their own stock options by failing to consider the time value of those options, it negates the incentive effects the company hoped to gain by issuing ESOs.
On the other hand, if employees incorporate a fuller set of information that captures the time value of the options, estimates of value may be positive even when the options are unvested or underwater, enhancing the incentive effects of the ESOs. How likely that is depends on the expected rate of return is it reasonable to expect that the stock price will grow?
Employees who use simple anchors in valuing stock options fail to appreciate that options are a long-term reward, and if stock prices are low today, they may rebound by the time the option is exercised in four, five, or even 10 years Hill and Stevens, The components to be considered for each option are provided in the table.
An employee who fails to understand how options work could significantly undervalue or overvalue the option. At one extreme, perhaps because the option is not yet vested, the employee may assign zero as a value for each option. This reflects an undervaluation because it ignores the future potential for exercising the option.
This employee stock option basics an overvaluation of the option because it ignores the cost of exercising the option the exercise price. A somewhat more sophisticated employee will recognize that the value of the option comes from the right to buy the stock for a price that is lower than the going rate.
A fairly simple calculation an employee may make is to compute the intrinsic value by taking the difference between the current stock price and the amount the employee would have to pay to exercise the option.
While this valuation strategy recognizes the intrinsic value of the option, it fails to consider the employee stock option basics that the stock price will change between today and the option exercise date, which may lead to a greater intrinsic value in the future; that is, the employee is employee stock option basics the time employee stock option basics of the option.
If the employee applies the Black-Scholes valuation technique that incorporates all the information available, including the time value that comes from the possibility that the stock price will increase by the exercise date, he or she would value the option at a much higher amount than the intrinsic value: Note that the option value will always be greater than the intrinsic value as the time value portion is always positive.
The calculations of the Black-Scholes model are not provided here; see Hill and Stevens,for more information on the specifics of this valuation technique. The greater the value an employee places on the stock option, the more likely employee stock option basics company realizes the ESO incentive benefits it desires. Because of this, some companies take various steps to encourage their employees to appreciate the full value of their ESOs.
The company believed that the program would make the value of stock options employee stock option basics more tangible to employees by showing that financial institutions were willing to pay more than the intrinsic value for their ESOs.
Other companies, however, have expressed reluctance to provide ESO education, in part because of concerns over the potential liability associated with discussing possible future stock prices Hodge et al. By granting ESOs, the company incurs an opportunity cost, in that the company could have instead raised capital by selling the stock option to outside investors in the option market. This opportunity cost is reasonably estimated by the Black-Scholes option-pricing model, which establishes the fair market value of a stock option traded on the exchanges.
We have employee stock option basics discussed the benefits a company can receive from granting ESOs, in terms of attracting, motivating, and retaining employees. Quantifying these benefits is challenging, but could be best employee stock option basics by the amount it would take in cash compensation to achieve certain desired outcomes.
In other words, what amount of cash would the company need to spend to attract new employees, retain them, maintain their job satisfaction, and motivate them to work hard to increase profits and ultimately higher stock prices? Other benefits of issuing ESOs to compensate employees rather than employee stock option basics and bonuses include conserving cash and the intangible benefit of making employees equity owners of the company. Only if employees perceive there to be value in employee stock option basics ESOs, including employee stock option basics underwater or unvested, will companies be able to make employee stock option basics and efficient use of ESOs as incentives in employee compensation packages.
To gain a better understanding of how employee stock option basics estimate the value of their stock-option compensation, co-authors Farrell, Krische, and Sedatole conducted a research study to examine the subjective values employees place on their ESO holdings, and the related impact of educating employees in more sophisticated option valuation techniques.
NWSIa national provider of decision support for equity compensation, the authors analyzed subjective ESO valuations made by recipients of stock options from five companies. We were granted access to this data on an aggregate basis under a confidentiality agreement.
Employee participants were first surveyed about their assessment of the value of their own ESO holdings. The survey included the following questions that required employees to indicate on a scale of 1 to 5 how strongly they agreed with each statement:. Employees were also asked about restricted stock holdings, but in fact, few employees held any restricted stock.
Employee participants then attended a 60—90 minute interactive group seminar in which they learned the fundamental concepts of option valuation according to the Black-Scholes option-pricing model, which included the employee stock option basics component of option valuation for example, the concept that underwater options still have value because they may become in-the-money at some point before expiration.
Available to the seminar participants were individualized equity compensation profile reports prepared by NWSI, based on company- and employee-provided information. Training, therefore, included both cognitive feedback about option-pricing concepts the pieces of information needed to compute ESO value and how to combine that information to form a judgment of value and outcome feedback about the model-based employee stock option basics of the ESO value numeric estimates of value based on the option-pricing concepts.
After training, of the employees completed an optional second copy of the stock option survey and an anonymous training evaluation form. We found that before training, 30 percent of employee participants relied on the three simple anchors to value their stock option holdings zero value, intrinsic value, or the current price of the underlying stock.
Our research design categorized employee valuations based on whole-portfolio assessments, so it is likely this percentage is much higher because of employees valuing some part of their portfolio on a simple anchor and other parts on other methods. After completing the ESO training program, only 23 percent of employee participants relied on the anchors.
A ratio lower than 1. A higher ratio, then, suggests that the employer will capture higher value because of higher employee subjective valuations, an issue addressed later regarding employee perceptions of motivation and loyalty.
The distribution of the ratio measure across the participants who provided estimates of value both before and after completion of the training program is shown in Figure 2. As a result of the training, Overall, then, training not only changed the way most employees valued their option holdings by moving them away from the use of simple valuation anchors, but increased the values they placed on their ESO holdings. Our study also found evidence that there are motivation and loyalty benefits that accrue to companies that issue ESOs.
Findings employee stock option basics Graduate Business Students We followed up our employee stock option basics of this real-world data with an experiment using masters-level business students, whom we assumed were a reasonable substitute for, and perhaps even better-educated in ESO valuation than, real-world ESO recipients.
Student participants valued a hypothetical ESO grant before training, and then revalued that grant as well as two additional grants after training. Training came in the form of a condensed educational program modeled after the NWSI seminar, but which included employee stock option basics cognitive feedback or outcome feedback about their hypothetical ESO holdings, as described earlier.
With respect to the use of the three simple valuation anchors, we can measure this much more precisely with the student participants because they all valued the same hypothetical ESOs rather than differing portfolios of ESOs.
We found that before training, After training, however, this percentage fell to 19 percent to 30 percent for the three different hypothetical ESOs. With respect to subjective valuations, we found the same pattern of results we found with employees.
After training, subjective valuations increased for employee stock option basics three hypothetical options valued. In addition, with the student participants we learned that subjective valuations of the hypothetical options are affected differently by the outcome feedback and cognitive feedback components of the training program. Finally, we asked the students what ESO valuation factors they found important when making their valuations to understand why valuations changed with training.
We found that those who relied on simple valuation anchors focused on stock price and exercise price, while those who used more sophisticated valuation methods incorporated more time-value factors into their subjective estimates of value such as stock price volatility, time to expiration, etc. Overall, cognitive feedback provides participants a better conceptual understanding of how the time value of money affects stock-option value.
Employee stock option basics implication for a company designing educational programs is that cognitive feedback could employee stock option basics more effective in the long term in accomplishing the incentive goals of an ESO program than training that merely provides numerical outcome feedback regarding the Black-Scholes option-pricing valuations. Corporate managers should know that educating their employees about sophisticated methods of valuing stock options is employee stock option basics the best interests of both the company and the employees Hill and Stevens, employee stock option basics However, communicating with employees about their equity plans is considered one of the most challenging aspects of offering equity compensation PricewaterhouseCoopers Companies are often reluctant to provide ESO education, in part because of concerns over the potential liability associated with discussing possible future stock prices Hodge et al.
Because of these challenges and concerns, there is a distinct role for professional financial planners to employee stock option basics in the education of clients who receive ESOs.