Valuation of Stock Option Grants Under Multiple Severance Risks

Abstract

Grants of stock options as part of total employee compensation are now commonplace, but how such options should be valued and reported in firm financial statements is still an unsettled issue. The Black-Scholes (BS) model is the best-known and most widely accepted approach to option valuation as a benchmark for accounting and legal purposes, so it is seems like a natural place to begin. However, employee stock options (ESOs) are subject to several additional contingencies that are not in the BS equation, but significantly alter the possible payoffs. Specifically, severance with or without cause, including by death of the option holder, typically alters the payoff on an ESO. For example, termination with cause may also entail forfeiture of the employee’s options; termination without cause may simply advance the option’s maturity date and require the departing employee to exercise immediately, or not at all. In this article, Pandher presents a risk-neutral valuation approach for pricing ESOs under a realistic set of severance possibilities and examines the impact on valuation and on expected exercise dates. He shows that proper treatment of these additional features can make a substantial difference in the ESO value relative to Black-Scholes.