Stock options, which allow employees to purchase company stock for an exercise price, can be a great reward for a job well done. The employer’s goal is to generate a personal, long-term investment and sense of ownership in valuable staff. But for many employees, ESOs are a confusing benefit whose value is hard to ascertain.
About 10 million employees held stock options as of 2010, according to the nonprofit National Center for Employee Ownership. Yet many employees undervalue their ESOs—and therefore fail to take full advantage of them, according to Associate Professor Susan Krische. She uses behavioral research methods to investigate how people evaluate, and use, financial information.
“Unless you’ve already been trained in how to think about stock options, they’re complicated animals,” Krische said. “We found that people tend to revert to fairly simple rules of thumb in evaluating employee stock options.”
These mental shortcuts, or “anchors,” simplify employees’ decision making on whether or not to exercise stock options and attempts to gauge their worth.
The problem, said Krische, is that employees often oversimplify, failing to consider the time element of ESOs that ultimately impacts their value. The time factor means, for instance, that the stock has one value today, but another on the day it vests—that is, when the employee is allowed to exercise the option, and potentially different values as time goes on—until the day that the options expire. When employees discount time value, they overlook the full range of valuation possibilities.
Employees often take one of three simplified approaches to evaluating ESOs, Krische said.
“Both groups are focused on the here and now, and I would say under-appreciate the possibility of what will happen in the future as the options continue to be available to them,” Krische said.
Finally, more savvy employees may calculate the option’s intrinsic value as the stock price minus the exercise price. But again, they’ve left out something important: time.
The stock price will fluctuate between today, when the employees evaluate it, and the last day that they could exercise the option. The value could rise above the exercise price, staying “in the money,” or it could fall below the exercise price, becoming “underwater.” Both have implications for the value that the employee is able to capture from the option.
According to Krische, the general recommendation is to hold onto options until the last possible date before they expire. If the option is in the money, exercise it; if not, let it go. Instead, many employees exercise their options as soon as they vest. Surprisingly, others simply let their options expire—even when they are in the money.
“There’s a lot of misunderstanding,” Krische said. “And often, employees are inadvertently leaving money on the table.”
Ain’t Got No Education
Fixing the problem might seem simple: companies could provide guidance to employees in valuating ESOs. But research has suggested that liability concerns make employers leery of being held to a stock value projection that might fail to materialize. As a consequence, companies may leave employees to sort things out for themselves.
Yet companies do have an interest in how employees perceive and value ESOs, so it behooves them to find a way to boost employees’ valuation skills. After all, a major purpose of ESOs is to incentivize, which only works if employees appreciate the options’ potential value.
Krische recommended that companies could nevertheless educate employees about the valuation piece most individuals overlook: time.
Because ESOs represent a future value—that is, the option to purchase a share of stock at some later point—researchers have debated for years how to value them, just as standard setters have debated whether and how to record these transactions in companies’ financial statements, she explained. A common valuation method has been the Black-Scholes option-pricing model, a mathematical formula originally devised for market-traded options.
And there’s the rub, according to Krische: ESOs differ from market-traded options, so some have argued that while Black-Scholes may be widely used, it’s not an exact fit. For one thing, employees typically have five to 10 years to exercise ESOs. There is a vesting period, which prevents employees from exercising options until a certain time has passed. Finally, ESOs may carry trading restrictions.
These factors made Krische curious about employees’ thought process when it came to valuing their ESOS. If employees better understood the fundamentals of valuation, she wondered, would they move away from applying simple rules of thumb and toward a valuation method that approximated a Black-Scholes estimate?
To find out how real-world employees value their ESOs, Krische and her coauthors, Anne Farrell of Miami University and Karen Sedatole of Michigan State University, obtained data from Net Worth Strategies, Inc., an Oregon-based firm that provides equity compensation decision support. They analyzed subjective ESO valuations from 210 employees of five companies who had received stock options and participated in ESO training programs.
The employees took surveys about their assessment of ESOs’ value and their perception of incentive effects. Then, they participated in a training session, which included the concepts of option valuation, based on the Black-Scholes model. Specifically, the employees learned to incorporate options’ time value—for example, an option that is underwater today still holds potential value because it could become “in the money” before it expires.
Employees received two kinds of training, Krische said:
In other words, they learned both a calculated outcome and a way to think through the valuation process themselves. After the employees completed their training, they took the survey again.
The researchers recorded a drop in the number of employees who relied on the three simplistic “anchors” to determine ESO value: from 30 percent to 23 percent. What’s more, when employees re-evaluated their ESOs after training, 71 percent increased their valuations.
The employees also affirmed that ESOs do indeed carry motivational and loyalty-inspiring benefits—a belief that further increased after training. To the researchers, that supported the relationship between employees’ valuation of stock options, their perception of benefits, and the payoff accrued to the company: “The greater the value an employee places on the stock option, the more likely the company realizes the ESO incentive benefits it desires.”
The researchers continued their analysis with an experiment involving 196 students in master’s degree business programs. These participants valued a hypothetical ESO grant, underwent a training session including either outcome feedback or cognitive feedback (or both), and then revalued that grant along with two other cases.
Again, results showed that training in valuation techniques led to a more sophisticated analysis. Before training, 46.9 percent of participants used one of the three simplistic methods. After training, only 19 percent to 30 percent did so.
Unlike participants who relied on simple anchors to value the ESO, those who used more sophisticated techniques incorporated a time-value factor, such as stock price volatility over time, or the fact that time remained before the options expired and thus their value could increase.
In this experiment, a key finding related to whether participants received outcome feedback or cognitive feedback training. Krische found that outcome feedback increased students’ valuations of ESOs, but cognitive feedback had more lasting effects.
For companies, this sheds light on how to help employees: “Cognitive feedback that provides participants with a better conceptual understanding about how the time value of money affects stock option value could be more effective in the longer term than training that merely provides numerical outcome feedback.”
Krische pointed out that this also could assuage companies’ concerns about getting too specific in discussions of ESO value. Instead, the research suggests, employees can develop more sophisticated valuations when they are shown how to think through the process; they may not be executing the Black-Scholes model, but they are much better off than when grappling with their own rough anchors.
Knowing that individuals revert to simplistic problem-solving aids when confronted with decision-making challenges, the trick is to arm them with useful tools, Krische said.
“On average, simple rules of thumb work well enough,” she acknowledged. “It’s just that ‘well enough’ in some circumstances isn’t well enough after all. There are circumstances where greater understanding and a more reasoned approach to analysis can lead you to a better outcome.”
“Employees’ Subjective Valuations of Their Stock Options: Evidence on the Distribution of Valuations and the Use of Simple Anchors,” coauthored with Anne Farrell and Karen Sedatole, was published in Contemporary Accounting Research in 2011.