How Employees Value (Often Incorrectly) Their Stock Options
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.
The survey asked the respondents to
provide an answer to the question, "How much cash would your company have to
offer you per option to return a fully vested stock option with seven years life
remaining"? In other words, "what is that option worth to you?" Five different
scenarios of exercise price and current stock price were examined (in decreasing
level of value): stock options that are in the money by 100% (i.e. the current
stock price is double the option’s exercise price), in the money by 10%, at the
money (i.e. the grant price is the same as the stock price at that date), out of
the money by 10%, and out of the money by 50% (i.e. the current stock price is
half of the option’s exercise price).
The results, shown in a graph, revealed that managers value their options
substantially above the Black-Scholes
value. For example, at-the-money options are valued at 50% higher than the
Black-Scholes value and options that are out-of-the-money by 50% are valued at
more than double the Black-Scholes value. These results, says Lambert, "indicate
that managers do not fully understand the value of stock options or possibly
their associated incentive effects."
Further analysis revealed that younger
employees at low managerial positions have the most upward bias in the perceived
values. In addition, employees who exercised options during the past year and
have higher expectations for future stock price performance place higher values
on their stock options. Consistent with traditional economics, employees who are
highly risk averse (or have a strong dislike of volatility in their wealth)
place a much higher value on in-the-money stock options and a much lower value
on out-of-the-money stock options. Finally, says Larcker, there is some
preliminary evidence that men do a slightly better job valuing stock options
than women.
In several instances multiple
employees from the same firm responded to the survey. The results for a firm
engaged in software development and consulting are presented
as are the results for a firm engaged in computer hardware manufacturing. With some
exceptions, the respondents valued their options above the upper bound computed
from Black-Scholes. Moreover, these figures revealed that employees generally do
understand how the value of a stock option decreases as the option falls further
out of the money. The figures also demonstrated that there is substantial
variation in the perceived value within managers of the same company. "The
extent of this heterogeneity is problematic for understanding whether stock
options provide the same incentives across the organization," says
Lambert.
Implications for
Firms
It is difficult to believe that stock
options have the desired effect on employee behavior if employees do not
understand the basic economics of stock options. Clearly employers need to
develop more sophisticated training programs, the researchers suggest. For
example, firms need to educate employees about the expected range of value for
stock options and perhaps point out that the expected value is probably less
than the Black-Scholes estimate.
Moreover, the training program needs
to be tailored to the bias associated with specific employee characteristics.
For example, younger employees in technical areas may have a different set of
problems understanding stock options than senior-level managers in
marketing.
Then there is what Larcker calls "more
devious behavior – the idea that firms can cut back the number of options
granted to employees in order to satisfy wage requirements." For example, assume
that the expected economic value of a stock option is $20, but the employee
overvalues the same stock option at (say) $40. In addition, assume that the
employee requires stock option value of $10,000 per year. How many options would
satisfy the employee: $10,000/$40 = 250? Clearly, the firm is using the bias of
the employee in order to pay him or her less (the employee should demand
$10,000/$20 = 500 options, and not 250 options).
The goal of this research is to understand how
employees value stock options and to identify the factors that cause employees
to over-value or under-value their options. If you are interested in surveying a
broad cross-section of your employees about how they value their options, please
contact David Larcker (larcker@wharton.upenn.edu)
or Richard Lambert (lambert@wharton.upenn.edu).
To get an idea about the survey, click
here:
To see a sample report from this survey (best
viewed using the Internet Explorer browser) click here.