Damodaran on Valuation

11.2. EMPLOYEE OPTIONS

Firms use equity options to reward managers as well as other employees. There are two effects that these options have on value per share. One is created by options that have already been granted. These options, some of which have exercise value today, reduce the value of equity per share, since a portion of the existing equity in the firm has to be set aside to meet these eventual option exercises. The other is the likelihood that these firms will use options on a continuing basis to reward employees or to compensate them. These expected option grants reduce the portion of the expected future cash flows that accrue to existing stockholders and thus the value per share today. In the subsections that follow, we begin by looking at trends in the use of employee stock options and the types of firms where option grants are largest. We also examine the characteristics of employee options and how they have been accounted for historically, revisit the debate on whether employee stock options should be expensed, and discuss the new accounting rules that will govern option grants.

11.2.1. Magnitude of the Option Overhang

The use of options in management compensation packages is not new to firms. Many firms in the 1970s and 1980s initiated option-based compensation packages to induce top managers to think more like stockholders. What is different about the more recent option grants, especially at technology firms? One is that management contracts at these firms are ...