Stock options represent a significant claim against companiesthat should be reflected in their valuations, but valuing employee stock options is complex. Fortunately, in this Research Foundation of CFA Institute monograph, Mark Lang presents an excellent framework for valuing these claims by balancing the obligation of the company to fund outstanding options and future grants with the benefits arising from the incentive effects of options.

1. Employee Stock Option Basics
To frame the discussion of options and equity valuation, it is useful to consider typical features of employee stock options and a basic approach for incorporating options in valuation. In this chapter, I develop a simple option example to highlight the economic implications of options for existing equityholders.

Then, I apply the implications from the example to a standard discounted cash flow model to highlight the effect employee options can have on equity valuation. In later chapters, I use the insights from the option example and equity valuation equation to emphasize the importance of the research findings for equity valuation.

A Typical Employee Option
Although the length of term varies across companies, a typical option has a 10-year life. Furthermore, the typical option is granted at the money, meaning that the strike price at which the option can be exercised is equal to the stock price at the time of the grant.

Therefore, if the stock remains below the price at grant date throughout its life, the option will expire valueless and the employee will have gained nothing. If the stock increases in value, however, the employee has the right to exercise the option and receive the shares at the strike price specified in the option agreement.

Typically, an option also carries a vesting period and schedule, such as 25 percent per year at the end of each of the first four years of the option’s life, limiting exercise until vesting has occurred. As do option lives, vesting schedules vary across companies. ...

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Mark Lang
Kenan-Flagler Business School
University of North Carolina
The Research Foundation of CFA Institute

Preface
One of the most striking developments in compensation has been the growth in importance of employee stock option plans. Stock option plans are pervasive among U.S. companies and of increasing importance internationally. Because options exact a significant cost from the existing shareholders and potentially affect managerial decisions, understanding the effects of options is important to understanding and valuing companies.

Furthermore, option accounting has proved very controversial. As the incidence of and controversy associated with options has increased, so has the research literature investigating many of the concerns.

The origins of employee stock options reflect the effort to tie compensation to employee performance. Holmstrom (1979) formalized the notion that companies face a fundamental trade-off in compensating risk-averse employees. On the one hand, incentives can be improved by tying compensation to performance and hence aligning employees’ incentives with shareholders’.

On the other hand, if employees are risk averse and performance-based compensation places risk on them, the employer will have to provide additional expected compensation for taking on the additional risk. ...

Contents
Foreword . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . vi
Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . viii
Chapter 1. Employee Stock Option Basics . . . . . . . . . . . . . . . . 1
Chapter 2. Expected Cost of Options. . . . . . . . . . . . . . . . . . . . . 7
Chapter 3. Patterns of Option Exercise . . . . . . . . . . . . . . . . . . . 25
Chapter 4. Option Value to Employees . . . . . . . . . . . . . . . . . . . 40
Chapter 5. Impact on Cash Flow and Valuation . . . . . . . . . . . . 46
Chapter 6. Summary and Application . . . . . . . . . . . . . . . . . . . . 56
Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69

About the Author
Mark Lang is Thomas W. Hudson, Jr./Deloitte and Touche L.L.P. Distinguished Professor at the Kenan-Flagler Business School at the University of North Carolina. Professor Lang’s research interests include stock market valuation of accounting information; international accounting and analysis; employee stock option valuation, taxation, and exercise behavior; causes and effects of voluntary disclosure; and multinational tax strategy.

His research on stock options has been published in the Journal of Finance, Quarterly Journal of Economics, and Journal of Accounting and Economics.

He has served on the International Accounting Standards Board’s Share-Based Payment Advisory Group and the American Institute of CPAs Blockage Factor Task Force. Professor Lang holds a BS from Sioux Falls College and an MBA and a PhD from the University of Chicago.

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