Non-marketability and the value of employee stock options

We adapt the Benninga et al. (2005) framework to value employee stock options (ESOs). The model quantifies non-diversification effects, is computationally simple, and provides an endogenous explanation of ESO early-exercise. Using a proprietary dataset of ESO exercise events we measure the non-marketability ESO discount. We find that the ESO value on the grant date is approximately 45% of a similar plain vanilla Black–Scholes value. The model is aligned with empirical findings of ESOs, gives an exercise boundary of ESOs and can serve as an approximation to the fair value estimation of share-based employee and executive compensation. Using the model we give a numerical measure of non-diversification in an imperfect market.     

How Might Companies Value ESOs?

There has been a steady growth in the use of employee equity compensation plans, and in the use of executive stock options (ESOs) in particular, along with a rise in shareholder and public perceptions that the values of compensation plans are not always fully disclosed. The IFSA of Australia recently called for separate reporting in financial statements of numbers and values of ESOs. Companies, when negotiating employment contracts, frequently agree to compensate an executive if a share option plan is subsequently not approved by shareholders. These facts suggest that reporting the value of an ESO plan is a useful and important exercise. We outline a model for the valuation of ESOs typically issued by Australian listed companies and illustrate the application of the model with a case study.     

Should there exist secondary markets for executive stock options?

This paper investigates the potential disadvantages of the secondary markets for executive stock options (ESOs). The benefits of such markets are evident, but they might also have negative effects for shareholders. Executives might, for example, use inside information to time their ESO selling. We investigate two personal motives of managers that can be assumed to affect their optimal selling decision, that is, managers' personal portfolio management issues and the use of inside information. We explore these motives by analyzing unique data from Finland, where there are secondary markets for ESOs. The results of the study support the traditional portfolio diversification hypothesis according to which managers tend to sell their ESOs when holding an ESO is equivalent to holding the underlying stock; that is, in such a case a manager's wealth is closely tied to the stock price of the firm. With respect to the use of inside information the results indicate that ESO selling activity is not related to future stock price behaviour, suggesting that managers do not use inside information to determine the selling time of their ESOs. These results imply that the existence of secondary markets for ESOs does not weaken the usefulness of ESOs as the management compensation, although the benefits of such markets are evident.     

Option Awards for Australian CEOs: The Who, What and Why

The compensation structure for Australian CEOs, and especially the extent to which they receive executive stock options, is explored. Evidence suggests that the award of executive stock options is common in Australia, but not in as systematic a manner as has been documented for US CEOs. Where ESOs are awarded, they form a significant component of total compensation, even allowing for limitations in the way we approximate their value. Modelling the use of ESOs shows relatively few empirical regularities, other than a positive association between firm size and ESO use. This is consistent with a view that ESOs are a form of "rent extraction" by CEOs, but it may also reflect a bias towards their use created by accounting rules.     

Repricing and employee stock option valuation

A repricing occurs when the issuing firm resets the strike price of an employee stock option (ESO). ESO repricings occur most frequently following a significant decline in the underlying stock price. Typically, the strike price is reset to the new stock price. We develop a new model for valuing ESOs with a repricing feature. Our valuation model is developed within a utility-maximizing framework that accounts for potentially multiple repricings, employee risk aversion, employee non-option wealth, the non-tradeability of ESOs, and the early exercise feature of ESOs. Simulations suggest that these factors can significantly affect ESO value.     

Employee Stock Options, Equity Valuation, and the Valuation of Option Grants Using a Warrant-Pricing Model

We investigate the use of a warrant‐pricing approach to incorporate employee stock options (ESOs) into equity valuation and to account for the dilutive effect of ESOs in the valuation of option grants for financial reporting purposes. Our valuation approach accounts for the jointly determined nature of ESO and shareholder values. The empirical results show that our stock price estimate exhibits lower prediction errors and higher explanatory powers for actual share price than does the traditional stock price estimate. We use our valuation approach to assess the implications of dilution on the fair‐value estimates of ESO grants. We find that the fair value is overstated by 6% if we ignore the dilutive feature of ESOs. Furthermore, this bias is larger for firms that are heavy users of ESOs, small, and R&D intensive, and for firms that have a broad‐based ESO compensation plan.     

再论经理人股票期权的会计确认

谢德仁和刘文(2002)提出了经理人股票期权会计确认的利润分配观。本文在此基础上进行进一步论证,认为经理人股票期权赠予交易的经济实质是股东为激励经理人而将部分剩余索取权(在财务会计意义上就是利润分配权)让渡给经理人,而不是经理人直接用服务来交换股票期权,经理人股票期权赠予并不以经理人服务的投入为必备前提,经理人股票期权赠予交易内含的价值运动是具有一定价值的剩余索取权(所有者权益)从现有股东那里来,流到经理人处去。因此,在经理人股票期权赠予交易的会计确认上,应将经理人股票期权的对应项目确认为企业的利润分配。     

Which approach to accounting for employee stock options best reflects market pricing?

We use a residual income valuation framework to compare equity valuation implications of four approaches to employee stock options (ESOs) accounting: APB 25 “recognize nothing”, SFAS 123 (revised) “recognize ESO expense”, FASB Exposure Draft “recognize and expense ESO asset” and “recognize ESO asset and liability”. Theoretical analysis shows only grant date recognition of an asset and liability, and subsequent marking-to-market of the liability, results in accounting numbers that capture the dilution effects of ESOs on current shareholder value. Out-of-sample equity market value prediction tests and in-sample comparisons of model explanatory power also support the “recognize ESO asset and liability” method.     

The Effect of Executive Stock Options on Corporate Innovative Activities

This study investigates whether the implicit optionality of executive stock options (ESOs) induce managers to undertake innovative activities associated with various types of risk. We find ESO risk incentive (vega) to be positively correlated with all types of corporate innovations. We also find greater ESO risk incentive effects for the product‐related innovative activities that are associated more with systematic risk than idiosyncratic risk. Finally, we document the following pecking order for the ESO risk incentive effects: improved product, new product, alliance, and new research and development. Our results suggest that executives have more incentive to invest in projects with higher systematic risk.     

The Valuation of Executive Stock Options in an Intensity-Based Framework

This paper presents a general intensity-based framework to value executive stock options (ESOs). It builds upon the recent advances in the credit risk modeling arena. The early exercise or forfeiture due to voluntary or involuntary employment termination and the early exercise due to the executive's desire for liquidity or diversification are modeled as an exogenous point process with random intensity dependent on the stock price.Two analytically tractable specifications are given where the ESO value, expected time of exercise or forfeiture, and the expected stock price at the time of exercise or forfeiture are calculated in closed-form.     

Executive stock option vesting conditions,corporate governance and CEO attributes: evidence from Australia

We investigate the association between executive stock option (ESO) vesting conditions, corporate governance and CEO attributes. Using observations from the 250 largest Australian firms, we find that stronger corporate governance is positively associated with the length of the vesting period and the use of performance hurdles. We also find that when CEOs approach retirement, firms are more likely to grant longer time‐vesting options but are less likely to impose performance hurdles. Further, more powerful CEOs appear to influence the granting of ESOs with less restrictive vesting conditions. Our findings suggest that both corporate governance and CEO attributes significantly shape the design of ESOs.     

ESO compensation: The roles of default risk, employee sentiment, and insider information

This paper derives a pricing model for employee stock options (ESO) that includes default risk and considers employee sentiment. Using ESO data from 1992 to 2004, the study finds that the average executive's subjective value is about 55% of the Black-Scholes value. Only employees who over-estimate firm returns (or insiders who know that the firm is under-valued) by about 10% per annum will prefer ESOs over cash compensation. Our model also shows that work incentives offered by ESOs may be far lower than those implied by Black-Scholes but that ESOs may induce less risk-taking behavior, contrary to typical moral hazard arguments. Findings may impact relevant accounting regulations as well as compensation decisions.     

Accelerated Vesting of Employee Stock Options in Anticipation of FAS 123-R

In December 2004, the Financial Accounting Standards Board (FASB) mandated the use of a fair value–based measurement attribute to value employee stock options (ESOs) via Financial Accounting Standard (FAS) 123-R. In anticipation of FAS 123-R, between March 2004 and November 2005, several firms accelerate the vesting of ESOs to avoid recognizing existing unvested ESO grants at fair value in future financial statements. We find that the likelihood of accelerated vesting is higher if (1) acceleration has a greater effect on future ESO compensation expense, especially related to underwater options, and (2) firms suffer greater agency problems, proxied by fewer blockholders, lower pension fund ownership, and top five officers holding a greater share of ESOs. We also find a negative stock price reaction around the announcement of the acceleration decision. Furthermore, stock returns are significantly negative before the new vesting dates and positive afterward, suggesting that vesting dates could have been backdated.     

Employee stock options pricing and the implication of restricted exercise price: evidence from Taiwan

Employee stock option (ESO) issuance in Taiwan is associated with some unique characteristics. We believe this to be the first paper to examine the impact of different pricing model options on the theoretical price of ESOs in Taiwan. A clear consensus in terms of the time point to expense the ESO issuance and the setting of a restricted exercise price lead us to believe that the reset pricing model represents the most pertinent model to price Taiwanese ESOs. Furthermore, the factors that determine the decision to impose a restricted exercise price are also discussed. With an outreach of 24 logistic regressions, the empirical results show that the ultimate control power, operational performance and volatility of a firm are important indicators regarding the probability of adding a restriction on the exercise price.     

What determines early exercise of employee stock options in Australia?

Employee stock options (ESOs) are a popular way of remunerating employees. We analyse factors at the firm and option level affecting the employee's decision to exercise ESOs before they mature. Exercises over the period 1998–2004 are analysed and the key factor influencing early exercise is found to be dividends. Exercises frequently occur well before maturity, but in most cases little time value is sacrificed. Our findings have implications for the ‘fair’ valuation of ESOs in companies’ financial statements, as required by the relevant Australian accounting standard, AASB 2.     

Discussion of “Financial reporting for employee stock options: liabilities or equity”

Barth, Hodder, and Stubben examine how the risk and expected return of existing shares varies as a function of the amount of outstanding employee stock options (ESOs), finding that the association is a negative one, consistent with ESOs being equity-like in character. They suggest that their approach could be used to address the question of how best to characterize other complex financial claims. The study is well executed and provides a thought-provoking contribution to the debate. However, it is far from obvious that the “debt or equity” question can be solved in this manner. Their approach effectively defines a liability as a financial claim that has characteristics akin to fixed-rate debt. I provide examples of the limitations of this perspective, starting by comparing ESOs that are settled with shares with those settled in cash. Whether a claim is treated as a liability or equity is of little consequence if it is simply a matter of balance sheet presentation. The real question is the implications for income measurement. I suggest progress might best be made if we start with Penman’s proposal that assets and liabilities be separated into operating and financial items, an approach which would include many claims that have equity-like characteristics, such as unvested ESOs, within the operating liability category. Once a claim ceases to be an operating item—e.g. when an ESO vests—the approach suggested in the paper can then be used to determine how it should be classified.     

The relation between corporate governance and CEOs’ equity grants

We investigate whether the firm’s corporate governance affects the value of equity grants for its CEO. Consistent with the managerial power view, we find that more poorly-governed firms grant higher values of stock options and restricted stock to their CEOs after controlling for the economic determinants of these grants. We show that the negative relation between governance strength and equity grants is not likely to be attributable to omitted economic factors or substitution effects between governance strength and equity incentives. As further evidence consistent with the managerial power view, we show that firms with poorer governance in the pre-Enron era cut back more on using employee stock options (ESOs) for their CEOs in the post-Enron era, a period when the accounting and outrage costs of ESOs increased, consistent with poorly-governed firms taking more advantage of opaque ESO accounting rules than better-governed firms. We show that the association between governance strength and abnormal equity grants is less negative in the post-Enron period than it was in the pre-Enron period, consistent with firms making more efficient equity-granting decisions after the corporate governance changes mandated by the Sarbanes–Oxley Act of 2002 and the major US stock exchanges took effect.     

A dynamic analysis of executive stock options: Determinants and consequences

We investigate the determinants of executive stock options (ESOs) and their impact on risky investment and subsequent firm performance in a dynamic setting. We find that, first, the dynamic response of ESOs to growth opportunity and risk is positive and lasts for two to three years. Second, the dynamic response of risky investments to option compensation is positive but converges to zero after three years. More importantly, the positive effect of ESOs on risky investments is observed when CEOs' personal risk-aversion is taken into account. Third, accounting performance responds positively to the risky, option-induced investment, but the dynamic effect lasts only for one year. Meanwhile, when managers undertake more risky investments than what ESOs imply, accounting performance responds negatively to the over-investment.     

Management compensation contracts and distribution policies in the US technology sector

This paper examines the impact of executive compensation practices on (a) the decision to distribute and (b) the distribution channel employed by companies from the US technology sector. We report that firms that compensate their managers using executive stock options (ESOs) tend to distribute less and firms that use stock awards make more distributions. When we simultaneously examine the distribution and the channel used, we find firms using ESOs restrict their dividend payments but their propensity for stock repurchases is unaffected. Firms using stock awards to compensate managers make greater distributions across all channels. We also provide strong evidence in favour of the agency and leverage explanations for distributions.     

Accounting For Employee Share Options

Accounting for employee share options (ESOs) has caused a furore in the United States. Understandably, Australian standard-setters are moving cautiously but have signalled they may follow the FASB's lead. ESOs are a major form of executive remuneration but have not usually been recognised in the employer's financial statements unless and until they are exercised. The FASB has proposed that ESOs be valued on their grant date and immediately recognised as an asset (prepaid compensation) and additional shareholders' equity (options outstanding); the asset is then to be amortised over the period in which the employee's services are received. We describe and comment on the debate, in the light of the proposal's likely impact on firms' financial profiles.