Employee Stock Options with Performance Conditions: Do Commonly Used Valuation Heuristics Work?

Abstract

Valuation heuristics are widely used in industry practice, policy documents, and several academic studies to value traditional time vesting option plans. This paper analyzes to what extent such heuristics also qualify for valuing performance vesting plans. To this end, we examine performance conditions tied to the underlying stock, the stock’s performance relative to a stock index and an earnings measure and derive optimal option exercises in a simulation framework. We investigate the valuation differences between the optimal exercise model, the commonly used adjusted maturity approximation, and the approach proposed by Hull and White (2004). For optimal exercise behavior, the changes in option costs due to the performance conditions we investigate are generally low. Only when the options represent a large fraction of the employee’s wealth do the performance conditions prevent value-diminishing early exercises and thus increase the option cost to the firm. The differences between the optimal and approximated option values are overall smaller with the performance conditions than without them. This can be mainly attributed to the fact that the performance conditions restrict the possible option exercise states and thus limit the effect of the misspecified true exercise boundary within the approximations.