How Employees Value (Often Incorrectly) Their Stock Options

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One of the more intriguing changes in executive and employee compensation is the increase in the use of stock options. Although much of the discussion about stock options has focused on "new economy" companies, there has been a corresponding increase in stock options grants for more traditional firms as well. The typical explanation for the use of stock options is that these compensation vehicles enable companies to attract and retain the best employees and also provide superior incentives for employees to increase shareholder value.

While these explanations seem reasonable on the surface, they hinge on the assumption that employees understand how stock options work. Yet according to recent research by Wharton professors David F. Larcker and Richard A. Lambert, employees, in fact, tend not to understand the basic economics of stock options - a finding that has important implications for employees, employers, boards of directors and management consultants.

Larcker' s and Lambert' s research, based on a survey of 122 Knowledge@Wharton readers conducted in March 2001, looked at what stock options cost the firm and at what value employees place on them. "For example, we found that some employees harbor unrealistic expectations as to what will happen to the stock price," says Larcker. "In other words, the employees value their options more than they are theoretically worth, which can cause human resource problems as well as raise certain ethical issues."

An earlier survey, this one conducted in May 2000 by OppenheimerFunds Inc., came up with some of the same conclusions although its scope was more limited. The survey, based on 107 respondents who owned stock options, found, for example, that 39% of option holders said they knew "little" or "nothing" about their options and another 35% said they knew only "something." As a strong indication of serious knowledge limitations, 11% of the respondents had allowed "in the money" options to expire, essentially rendering them worthless. Finally, 52% said they knew "little" or "nothing" about the tax implications of exercising options.

A Primer on Stock Options

Stock options are deceptively simple compensation contracts. When an option is exercised, its payoff rises by one dollar for each dollar the stock price is above the exercise (or strike) price. If the stock price is below the exercise price when the option matures, the option is left unexercised and its payoff is zero.

What stock prices will be five to ten years in the future are, of course, unknown at the grant date. As a result, many firms rely on a valuation model to determine the cost of granting an option. One common valuation methodology is the Black-Scholes approach, which is easy to compute with widely available programs and provides a reasonable indication of the expected cost to the firm of granting a stock option. For a typical company, the Black-Scholes value of an executive stock option granted at the money - where the grant price is the same as the stock price on that date - is 30% to 50% of the current stock price.

Although the cost to the firm can be reasonably estimated, the value of the stock option to an employee is not simply the Black-Scholes value. This is because the wealth of employees is much more highly tied to the value of the firm than is the wealth of well-diversified outside investors. Employees, who are contractually forbidden from selling their options to outside investors, therefore have less ability to hedge the risk associated with holding options, and they are more likely to exercise options early for both liquidity and risk reduction reasons.

In general, the value of a stock option to a risk-averse employee can be substantially below the firm' s cost of granting the stock option. Thus, the value of a stock option to an employee should not exceed the Black-Scholes value of the option.

Black-Scholes and other similar models provide theoretical figures for the cost of the option to the firm or the upper bound to the value of the option to the employee. However, almost nothing is known about how employees actually value their stock options. The key issue is, "What do employees perceive an option to be worth?" Providing an answer to that question has profound implications for designing compensation programs.

It was also one of the questions asked by the Larcker and Lambert survey, conducted with iQuantic Inc. The survey participants were managers or top-level executives from 98 different firms. The typical respondent was 36 years of age, had been employed by his or her company for five years, earned cash compensation of $135,000 and held equity in their company of $50,000. The typical respondent had been granted options three times by his current firm and had exercised options once.

Given the timing of the survey, it is not surprising that stock prices of many of the respondents' firms had fallen during the previous year; the average one-year stock price return (volatility) preceding the survey went down 50%, and the average volatility was 98%. However, the respondents thought that their firm' s stock price during the next year would increase by an average of 96%. So, despite poor recent stock price performance and high volatility, the respondents appeared very optimistic about the future.

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