IntheacademicliteratureonESOs,researchershavefocusedontwopr in cipalareas. ResearchsuchasHull and White ,F in nerty ,Larker,Lambert, and Verrecchia ,Cuny and Jarion ,Hall and Murphy , and Jassnikc,Wiener, and Zapatero developoption pric in g models that account for the unique features associated with employee stockoptions. This body of research generally suggests that the st and ard BS model tends tooverstate the value of employee stock options.

For in stance, Hall and Murphy f in dsexecutive stock options are worth 20 to 60 percent of their BS model value while F in nerty f in dsthatatthedateofgrantESOareworthabout50percentoftheirBSmodelvalue. Thelatticetreeb in omialmodeldeveloped in Hull and White isparticularlyappeal in gforuse in litigationsett in gs. TheHull and White model,whichisrelativelystraightforwardtocalculate,accountsforvest in g,forfeiture, and employeeexercisepatterns.

Theb in omialstockpric in g models also allow for the in corporation of different stock price volatility for differenttimeperiods. Accord in gtorecentresearchbyRadfordConsult in g,theuseofb in omialbasedoption pric in g models has in creased significantly s in ce the adoption of F in ancial Account in gSt and ards FAS ,whichrequiredthevaluationofstockoptionstobedeductedfrom in comestatementsbeg in n in gafterJune15, Incontrasttothetheoretical and optionpric in gliterature,empiricalresearchonESOsuchasCarpenter ,Huddert ,Huddert and Lang ,hastendedtofocusontheactual5.

For in stance, Carpenter f in dsthat in dividualstendtobasetheirexercisedecisionsontherelationshipofthestockprice and grant price. The research f in ds that on average employees exercised their stockoptionswhenthestockpricewasabout2. Theoptionpric in gmodelsusedtoestimatetheCEOsallegeddamagesaredescribedbelow.

In the analysis in this case study, thest and arddeviationofdailystockreturnsfromthepreviousyearisusedtoestimatethestockpricevolatility. SomeresearcherssuchasHull suggestthatasageneralruleofthumbthedailystockreturnsfromatimeperiodthatisequaltothelengthoftheoptionshouldbeusedtocalculatestockpricevolatility.

Theyshow that assum in g there is no arbitrage and in vestors are risk neutral, the value of anemployeestockoptiongrantisequaltotheprobabilityofvest in gtimesthevalueofthefullyvestedcalloptioncounterpart. To my knowledge, the literature does not provide a set methodology for estimat in g theprobabilityofvest in gparameter. Inthiscase,thedefenseexpertuseddataontheaveragejobtenureforexecutivesatthecompanytodeterm in etheprobabilityofvest in gparameterused in thevaluation. Latticetreemodelsuseestimatesofstockpricemovementsovertimetoestimateyearendshareprices and ultimatelyESOvalues. Figure1 in theappendixpresentsanexampleofthelatticetreemodelforahypotheticalthreeyearemployeestockoption.

Asshown in thefigure,ESOvalues in thesemodelsaredeterm in edbyfirstcalculat in gthesharepriceattheendofeachyear in thelatticetree. TheESOvalueateachyear,ornodeofthetree,isdeterm in edbycalculat in gtheexpectedreturnateachnodeofthe tree. The expected value is determ in ed us in g the probability of upward and downwardstockpricemovements and theriskfree in terestrate.

Thef in alvalueoftheESOisdeterm in edbymov in gbackwards in thelatticetree.

Allotherfactorsequal,highercompanystockpricevolatility in creasesthevalueof an ESO because higher volatility creates a greater probability of upward stock pricemovements. Longer vest in g periods which in crease theexpectedexercisetimeultimately in creasesthevalueofESOs. Interest rates are in verselyratedtoESOvaluesduetothetimevalueofmoneyTheHull and White b in omialmodelutilizedbythedefenseexpert in thecaseisdescribedasfollows. Ateachnodethetree denotesthestockpriceatthenodeofthetreeattime and isthevalueoftheESOatthenode.

Further, ESOs are assumed to be exercisable after the end of the vest in g period and will beexercisedpriortomaturityifthestockpriceisatleastMtimestheexerciseprice. Additionally,thereisprobabilitythattheoptionwillbeforfeitedeither in thevest in gperiodorafterthevest in gperiod. Iftheoptionisterm in atedshortperiodsafterthevest in gperiod,theoptionisforfeitedoutofthemoney and exercisedimmediatelyifitis in themoney.

The follow in g equations describe the backwards in duction through the tree that is used toprovideavalueoftheESO isatthegrantdate. Thestockpric in gformulaisdeterm in edasfollows. Table2presentstheESOvaluesforeachofthemodelsestimatedbythepla in tiff and defenseexperts. Theparametersthatareusedtoestimatethemodelarefound in notesofthetable. Asis consistent with the literature, the BS model generated values that were higher than theb in omial model.

The unadjusted BS and the b in omial model valuation differential wasapproximately TheBSmodeliscalculatedasus in gthefollow in gparameters:,. Asmentioned,thecompanywasnotallowedtoredeemanyemployeestockoptionsdur in gthistimeperiod. TheCEOallegesthathadshebeenabletoexerciseheroptionsdur in gthisblackoutperiodshewouldhaverealizedahigherga in thansheactuallydidfromheroptions.

How Do We Value Share Based Compensation?

The unvested ESOs vested 6monthsaftertheblackoutperiodwas in stituted. TheCEOtestifiedthatonaparticularday,whichwasdur in gthe18monthblackoutperiod,shecontacted her broker and in quired if the blackout period concern in g the redemption of ESOgrants was still in place. She stated that on this date she wanted to exercise her employee9. Over a several month period, the CEO was able to exercise her options after the blackoutperiodended.

A Case Study in Valuing Employee Stock Options and Restricted

ThedefenseexpertbasedhiscalculationonthedifferencebetweenthevalueoftheESOsatthebeg in n in goftheblackoutperiod and thevalueoftheESOsattheendoftheblackoutperiod. Theanalysisisshown in Table3. Thevaluationoftheallegeddamagetotheunvestedoptionswasperformed in asimilarmanner. DiscussionClearlythesubstantialdifference in theeconomicdamagesop in ionsprovidedbythepla in tiffs and defense experts are driven by the significant differences in the methods that wereemployed.

Further,s in cethevaluationisdoneasofthedatethattheoptionswouldhavebeenawarded,theoptionpric in gapproachismoreconsistentwiththeunderly in gdamageconceptofmak in gthe in dividualwholeasofthedateofthebreachofcontract. S in cetheESOsarenotactuallytradableortransferrable, the pla in tiff could not have actually sold the options to realize the returnssuggestedbytheoptionpric in gmodel. Furthermore in thiscase,theestimateoftheexpectedvolatilityofthecompanystockwasofconcern in the valuation of the ESOs us in g the option pric in g models.

Inalitigationsett in g,thepastemployeestockoptionredemptionbehaviorcanbeparticularlyuseful.

PastESOredemption behavior can also be used to assess the reasonableness of assumptions used in in tr in sicvaluationsofESOs. The prom in ent position of the pla in tiff with in the company and the large number of stock in volved,suggestedthatseveralotherconceptualESOvaluationissuesbeaddressed.. First,theCEOwasakeyexecutive in thecompany and exertedmanagerialcontroloverthecompany.

Second,someresearchsuchasHuddart suggeststhattheESOforfeitureratemaychangeafterthevest in goccurs. For in stance,beforetheoptionisvestedtheemployeemaybemorelikely to leave company or other forfeit the option s in ce the ESOs were not exercisable. Conversely, an employee may be less likely to forfeit an option after vest in g s in ce theypotentiallymaybeforego in gf in ancialga in s. However,additional in formationontheactualESOforfeiture and employeetenurewouldbeneededtodeterm in eifthisfactoris in deedanissue. Huddart and Lang suggest thatemployees in more profitable companiesmaybelesslikelytoleave and foregotheperceivedgreaterlikelihoodof in creasedprofitability in thefuture.

Fourth, in casessuchasthis,wheretherearealargenumberofESOsatissue,issuesrelatedtostock dilution need to be considered in the analysis. BreachofContractAllegation3:FailuretoawardrestrictedstockF in ally, the executive alleges that she should have received ,00 shares of restricted stockfromthecompanyTherestrictedstockatissuerequiredthattheCEOholdthestockforoneyearbeforeitcouldbesold. Thatis,assum in gthattheCEOwouldhavereceivedthesharesshewouldnothavebeenabletoimmediatelysellthestockonthedateofissue.

If the companyactuallyhaspublicallytradedfuturesoptionthenthemarketvaluesoftheoptionscanbeusedto determ in e the amount of the discount. Inthiscase,thecompanydidnothavepublicallytradedoptionssonomarketbaseddiscountcould be calculated. For simplicity purposes, the low end illiquidity discount factor rangesuggestedbytheliteraturewasselected and used in theanalysis.

I discuss approaches used to account for the unique ESO valuation relatedissues that arise in litigation. The case study illustrates the importance of in corporat in g casespecific factors, such as the pla in tiff's historical ESO exercise rates and firm specific ESOforfeitureprobabilities, in tothevaluationmodels. In the figure, the stock prices at the end of each period are thenumbers in theboxthatarewithoutparentheses. The in tr in sicvalueofthestockoptions,thatis the stock price m in us the grant price, at the end of each year are the numbers conta in edwith in theparentheses.

Thevalueofthestockoptionattheendofeachofthethreeyearsisshownbythenumbers in brackets. Asequations 5 through 12 in thepapershow,stockpricesmovementsareafunctionofstockvolatility, in terestrates, and time. Theprobabilityofanupmovement p is0. The second step is to calculate the return that the employee would realize at each pricerealization in thetree.

Toillustrateconsiderthe in tr in sicoptionvaluesshown in thetopbox in yearthree. Atthisnode in thetree,theemployeewouldexercisethestockoption and realizea Some of this trend can be attributed to the entry of young, cash poor technology firms into the market, many of which have to use equity because they have no choice.

Employee Options, Restricted Stock and Value. Aswath Damodaran 1

However, many larger market cap firms that can afford to pay cash compensation have used stock based compensation as a way of aligning managerial interests with… Expand. View via Publisher. Save to Library. Create Alert. Launch Research Feed. Share This Paper. Background Citations. Results Citations.

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