Valuing Employee Stock Options

doi:10.2469/faj.v50.n6.46

Nalin Kulatilaka
Alan J. Marcus

The Financial Accounting Standards Board (FASB) is considering a controversial proposal that will require firms to calculate and recognize as a cost of compensation the value of employee stock options at the time those options are granted. Conventional option pricing models, however, are not well suited to the valuation of employee options because such options are nontransferable and, therefore, may be exercised early when an unconstrained investor ordinarily would sell the option. Thus, conventional pricing models can substantially misvalue employee options. The model of option valuation presented here accounts for an employee's propensity to exercise an option early. It shows that (1) employee stock options may be worth much less than would be suggested by conventional models, even using expected terms as low as one-half the stated option life; (2) the values of employee stock options are sensitive to variables that do not even appear in conventional option pricing models; (3) the values of employee stock options may fall when stock volatility rises; and (4) values of employee options can be less than the "minimum option value" that has appeared in the accounting literature.

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