Analytic Pricing of Employee Stock Options

We introduce a model that captures the main properties that characterize employee stock options (ESO). We discuss the likelihood of early voluntary ESO exercise, and the obligation to exercise immediately if the employee leaves the firm, except if this happens before options are vested, in which case the options are forfeited. We derive an analytic formula for the price of the ESO and in a case study compare it to alternative methods. Since the mid-1980s, stock options have been a substantial component of com-pensation packages for employees. For example, in 1999, 94 % of companies in the SP 500 offered stock options to their top employees (see Murphy, 1999; Hall and Murphy, 2002). In 1995, the Financial Accounting Standards Board (FASB) (with FAS 123) set a standard that required firms to expend stock-based compensation at the moment the compensation was granted (see FASB, 1995). Firms were encour-aged to use the “fair value ” of the stock option to compute the value of the compensation, but were allowed to use the “intrinsic value”—market price of the stock minus strike price. Since employee stock options (ESOs) are typically granted at the money, the intrinsic value is zero, which results in no expense recorded at the time of the grant, and this is probably one of the reasons that helped their popularity.