Derivatives: Markets, Valuation, and Risk Management

CHAPTER 13

Compensation Agreements

Firms often struggle with identifying appropriate compensation packages for their employees. One important ingredient in designing such a package is stock ownership. By providing employees with the shares of the firm, or claims on the shares of the firm, management aligns the interests of employees with those of owners (i.e., the shareholders). Two common contracts used in this context are an employee stock option (ESO) and an employee stock purchase plan (ESPP). Like a warrant, an ESO is a call option contract issued by the firm. Typically, ESOs are at-the-money at the time of issuance (i.e., the exercise price is set equal to the stock price) and have terms to expiration of ten years. Over the first few (usually three) years, the options cannot be exercised. This is called the vesting period. If the employee leaves the firm during the vesting period, the options are forfeit. After the vesting date, the options can be exercised at any time but are nontransferable. Because they are nontransferable, the only way for the employee to capitalize on its value is to exercise the option. An ESPP allows the employee to buy the company's stock at a discount, usually 15%, within a certain period of time, typically six months. Some the ESPP includes a lookback provision that allows its holder to apply the discount to either the end-of-period or the beginning-of-period stock price, whichever is less.

The purpose of this chapter is to describe how to value ...