Employee Stock Option Value and Employee Concentration Risk
Summary
The document discusses how employee stock options are valued and why their risk to an employee can differ from their market value. It notes that turnover may be modeled like a dividend yield in a Black–Scholes framework, reducing call value. The question raises whether the return distribution of small-company shares, including a possible pattern of many large losers and a few winners, could affect valuation, but it provides no data or model testing that claim.
The response explains that high underlying volatility generally increases an option’s theoretical value, while emphasizing risks to the holder: early exercise costs, income-tax treatment, and poor diversification. An employee’s wages and option holdings depend on the same company, so company distress can harm both at once. This concentration can reduce the options’ value to the employee on a risk-adjusted basis. The discussion is qualitative and does not estimate fair value, quantify tax effects, or specify how to model turnover or skewed returns.
Key ideas
- Higher underlying volatility generally raises a call option’s theoretical value.
- Employee turnover can be treated as a dividend-like input in an option valuation model.
- An employee’s wages and employer stock options share exposure to the same company.
- Tax treatment and early exercise costs can affect the value of options to their holder.
- Concentrated employer exposure may reduce risk-adjusted value even when theoretical option value is high.
Tags
Full text
# Pricing employee stock options # Pricing employee stock options ESOs are typically priced using the black-scholes model, but with an additional parameter for for the employee turnover rates . An example http://www.investopedia.com/university/employee-stock-options-eso/eso3.asp I assume that employee turnover rate can be modeled as a dividend-like parameter on the original black-scholes equation, which makes calls cheaper. But what about the distribution of stock returns? What if 90% of companies with a market cap of less than $200 million (or some size) lose 90% of their market-cap within a decade, and that the expected return is less than than the broader market? (meaning a few winners and lots and lots of losers) Given the high failure rate of small businesses, employee stock options maybe vastly overvalued ## Answer by jaamor (score 1) https://quant.stackexchange.com/a/18548 Employee stock options (ESOs) have a couple of disadvantages, but the high volatility of small tech company stocks is NOT one of them. It is actually an advantage, as the higher the volatility of the underlying, the higher the option value. Disadvantages for ESO holders: - Withholding fees for early exercise. - Income tax treatment instead of capital gains. - Decreased portfolio/income diversification. I will expand on the last one as I think it could be often overlooked. An employee works for a small to mid-sized tech company and holds ESO of the company. If the company goes south, the employee is in danger of not only losing her income stream but also sustaining great losses on the ESOs. The employee's income stream and portfolio value are greatly correlated and unless steps are taken to hedge and diversify, ESOs will represent less value to the individual on a Risk Adjusted basis.
Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.