Employee Stock Options and Equity Valuation by Mark Lang

By Mark Lang

Inventory innovations symbolize an important declare opposed to companiesthat might be mirrored of their valuations, yet valuing worker inventory concepts is complicated. thankfully, during this learn starting place of CFA Institute monograph, Mark Lang provides a superb framework for valuing those claims by way of balancing the duty of the corporate to fund awesome thoughts and destiny promises with the advantages coming up from the inducement results of techniques.

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In terms of predictability, the timing of option exercise is variable across grants, adding noise to the process of estimating typical option life. For a company such as Dell, actual exercise experience on an individual grant basis is likely to deviate substantially from the five-year assumption. That result is not particularly surprising because, for example, cases in which stock price appreciation is limited after grant will naturally result in longer option lives. The findings suggest that care should be taken when attempting to predict future option exercise behavior based on past behavior.

Casual observation and academic research point to the pervasiveness of early exercise. Exercise typically occurs as early as halfway through the option’s life, as in Dell’s case when exercise is assumed to occur, on average, 5 years into the option’s 10-year life. Furthermore, the cost to the company of a 10-year option is substantially higher than the cost of a 5-year option. 04 computed based on an assumed life of five years. As a consequence, the FASB has realized that any option-valuation approach should permit use of an assumed life much shorter than the contractual life.

Exercise is positively related to recent vesting. In the months immediately following vesting dates, exercise tends to be elevated because the vesting constraint has been binding for some employees who wished to exercise early in the option life. For example, in the case of companies with long vesting schedules, such as Dell, some employees may be so risk averse that they exercise as soon as they get a chance. Similarly, among options that are relatively deep in the money and about to vest, exercise will tend to be high following vesting.

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