Employee Stock Options

Employee stock options are usually granted to management personnel to attract talent and to motivate them to increase the value of the company, and, therefore, its stock price. Employee stock options give the employee the right to buy company stock after a stipulated period of employment for a stipulated price that is usually equal to the price of the company's stock when the stock option was granted. The recent news about back-dated options involves specifying a date previous to the actual granting of the option to when the stock price was at its lowest, thereby making the stock option grant more valuable, but not accounting for the added expense in financial statements.

Employee stock options differ from exchange-traded call options because

Evaluating employee stock options

Stock options have value, so if a company grants employees stock options, then the company is giving something that has value. If the company sold the options to the public, it would have more cash. Indeed, when the employee exercises the option, the company can deduct the market value of the stock in its taxes. By giving it to employees, it is giving an equivalent of cash, and, therefore, it should be expensed on the company's income statement. However, many companies have resisted this, because it will result in lower reported earnings.

The purpose of evaluating employee stock options is to determine the impact on company earnings such grants have. Previously, many companies, particularly high-tech companies that used them extensively to attract top talent, reported the option grants in footnotes rather than as a compensation expense, which would lower reported earnings. On the other hand, it is more difficult to evaluate footnotes than to compare numbers among different companies. Now that companies are required to expense option grants, they are looking at various ways to determine a value for the granted options.

Various pricing models are used, especially the Black-Scholes formula, which is commonly used to valuate exchange-traded options. The problem with using pricing models is that different companies can use different models, and, thus, it may be misleading for investors to compare the financial numbers of one company with another. A further complication is that a major component of all pricing models is the volatility of the stock, which must be estimated.

One company, Zions, tried a marketing approach by creating options with similar terms to employee stock options, then sold them to accredited investors at an auction. The options sold for half of what pricing models would have predicted. However, this market-based approach may be flawed, due to the number and sophistication of the bidders, and various other factors.

Is the Market Value of an Employee Stock Option Really a Better Indicator of the Actual Expense to the Company?

It seems unlikely that the market value of an employee stock option will be equal to its actual expense to the company, for they are not really connected. Companies, of course, prefer the market value if it lowers the compensation expense, and Zion's experiment would seem to indicate that. Of course, if pricing models yielded a lower figure, then companies wouldn't even be talking about using the market model, which has its own problems, such as actually issuing the securities and selling them in a bidding auction. The companies just want a lower expense number, which will result in higher reported earnings. It may be better to require companies to use a single pricing model so that investors can compare apples to apples.

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