Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options

CHAPTER 21

EMPLOYEE STOCK OPTION VALUATION WITH AN EARLY EXERCISE BOUNDARYa

Neil Brisley and Chris K. Anderson

Many companies are recognizing that the Black–Scholes formula is inappropriate for employee stock options (ESOs) and are moving toward lattice models for accounting or decision-making purposes. In the most influential of these models, the assumption is that employees exercise voluntarily when the stock price reaches a fixed multiple of the strike price, effectively introducing a “horizontal” exercise boundary into the lattice. In practice, however, employees make a trade-off between intrinsic value captured and the opportunity cost of time value forgone. The model proposed here explicitly recognizes and accounts for this reality and is intuitively appealing, easily implemented, and compliant with U.S. accounting standards.

Another assumption that Lehman made in valuing Mr. Fuld’s pay in 2000 was that he would exercise the options two and a half years after receiving them. But Mr. Fuld had a history of holding onto his options until they were about to expire. Indeed, all 2.6 million options that Mr. Fuld has exercised since November 2003 were in the last year of their life when he did so.

—Patrick McGeehan (2006)

The need to value employee stock options (ESOs) for accounting and economic purposes makes the modeling of employee early exercise behavior relevant for corporate financial officers, security analysts, and those involved in determining option awards. Early exercise ...