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Quantifying Lack of Marketability Discounts of Employee Stock Options.

Article Excerpt
It is well known that the cost of expensing employee stock options (ESOs) through the income statement is enormous, representing an aggregate additional expense for firms amounting to billions of dollars. Traditional option pricing methods clearly overstate the value of ESOs. Since the ESO's cost to the employer depends not only on the variables contained in option pricing models but also on the interrelationship of these factors unique to ESOs, the traditional option pricing models will overstate the value of an ESO unless adjustments are made to the valuation model to account for the unique issues associated with ESOs. Specifically, the exercise policy of the employee, the contingent nature of ESOs, and the lack of an organized exchange to buy and sell ESOs must be considered.

Black-Scholes not fully applicable to ESOs

While the underlying assumptions of the Black-Scholes option-pricing model - the most widely used method - approximate the characteristics of publicly traded stock options, they do not parallel the structure of ESOs. For example, the Black-Scholes option-pricing model assumes the use of a European option. European exercise terms dictate that the option can only be exercised on its expiration date. In contrast, the exercise term for an American-style option, including a vested...

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