Employment

Employee Compensation: Valuing Stock Options

by Brian P. Sullivan, Ph.D.

Employee stock options give rise to a variety of damages claims in wrongful-termination suits and other types of employment actions. Often, however, these claims do not take into account some fundamental features of ESOs.

Primer on Employee Stock Options

An option is a contract giving the option owner the right to purchase shares of stock at a preset price for a specified period of time. Employee stock options (ESOs) are used by companies to reward and retain key employees. An employee who has been granted an option must wait until the option vests before the option may be converted into shares of company stock. ESOs vest in accord with the employee stock-option plan (ESOP). If the employee leaves the company, the employee normally loses options that have not yet vested.

Once the option vests, the employee may realize the value of the option by exercising it -- the company permits the employee to buy a specified number of shares of the company’s stock for the price specified in the option contract. This preset price is called the strike price. The value the employee realizes is the difference between the market price of the stock and the strike price. If the strike price is less than the price of the company’s stock on the open market, the employee may make an immediate profit by buying the stock at the lower, preset price and then selling it at the current market price. However, the employee might choose to hold on to the option, betting that the market price of the stock would rise even further. A third alternative is to exercise the option and keep the stock shares, rather than selling them on the open market for an immediate profit. If the strike price is greater than the market price at the time of vesting, the employee may hold the option, hoping that the market price goes up above the strike price. One thing that the employee cannot do is sell the ESO directly in the open market. Unlike marketable options, which are traded daily in a market similar to the stock market, corporate options are not negotiable. (Also, employee option plans are not regulated by ERISA.)

The period during which the option may be exercised is called its duration, which for ESOs is usually ten years. Under many option plans, if the employee is terminated, the duration window is shortened to a few months following the employee’s separation from the company.

In suits brought by terminated employees, damages claims involving ESOs may rest on questionable assumptions, or may overlook some fundamental features of options.

For example, an employee who has left the company before the options in question have vested may claim to have lost the current market price of the company stock, minus the option strike price. This claim, however, is, in effect, a prediction of the stock’s price on the day the options would have vested. A similar claim may be made by terminated employee forced to exercise vested options within a short time frame: that the terminated employee lost out on future gins in company stock. However, the exercise of an option does not require immediate sale of the stock. The employee could have purchased the stock at the strike price and then held on to the stock to enjoy future appreciation.

Terminated employees who have lost options have also claimed as damage the highest price of the stock between termination from the company and present. This is actually a claim that the employee would have sold at the top of the market. However, accurate market timing is extremely rare.

A Note on Black Scholes

Black-Scholes is a theory of options pricing devised in 1973 by Fischer Black and Myron Scholes, two finance professors. Scholes was later awarded the Nobel Price for it (Black had passed away). The Black-Scholes option pricing is the method of options valuation required by the Financial Accounting Standards Board in filings seeking approval for employee stock options plans.

In seeking the value of an option, Black-Scholes employs a complex formula that considers the current price of the stock, the strike price, the risk-free interest rate (e.g., the current rate on Treasury securities), the amount of time until the option expires, the company’s dividend on the stock, if any, and the volatility of the stock. All of these variables are known with certainty except the volatility of the stock, which must be estimated. Usually, volatility is calculated as the historical standard deviation in the stock’s price, i.e., the past as predictor of the future. But what if the company is changing in fundamental ways? IBM was king of computing from 1950s until the mid-1980s, then precipitously lost its place in the microcomputer revolution. Thus, the historical volatility of IBM would not, in 1985, be a good predictor of the future volatility of IBM.It should also be noted that Black-Scholes strictly applies when the option is negotiable, yet company-issued employee stock options are not negotiable. To be useful in determining damages in an employment matter, arguably, a "lack-of-marketability" discount would need to be included in the Black-Scholes calculation.