Market Valuations for Employee Stock Options

In his comments to this post, Jeffrey Miller points us to an excellent discussion from Roger Lowenstein:

But as Alan Greenspan and Warren Buffett have observed, they aren’t “free” in an economic sense. Like other forms of compensation, options bear a cost to the corporation. But what is that cost? … Academics have been devising formulas to value stock options for decades; the creators of the Black-Scholes formula, the first such attempt to be widely adopted, won a Nobel Prize … Black-Scholes was developed for plain vanilla options that trade on exchanges. Employee options cannot be bought or sold, and under certain conditions (if the employee quits or is fired, for instance) they are cancelable. Therefore, it is reasonable to suppose that such options are worth less than vanilla. But how much less? Cisco’s solution would delight Adam Smith. Instead of using a formula to derive a value, the company plans to issue new derivatives, similar to the options granted to its employees, and to sell these derivatives to willing buyers. The price that the buyers pay would represent the true “cost” of the employee options.

Lowenstein properly notes that we are talking the market price at the time the option is granted – as the value of an option can change over time. Tim Reason was confused as to this point as we noted on June 8, 2004:

He then notes a statement from Kim Boylan, counsel to the International Employee Stock Options Coalition, also suggesting this evidence indicates problems with the SFAS 123 estimated value. But does this difference in the estimated value in 2002 versus the market price in late 2003 represent a concern that the SFAS 123 footnote seriously overstated the true value of the ESO or is this simply a reflection of the change in the value of Microsoft’s ESOs over this period? Using reasonable assumptions, a Black-Scholes model would predict a decline in value for these options near 80%.

Lowenstein continues:

Cisco intends to sell the warrants in an auction, but the auction would probably be open only to a dozen or so institutional bidders, which Cisco (or perhaps Morgan Stanley) would preselect. This has raised concerns. Since when did limiting the number of potential bidders lead to the most accurate price? What’s more, the fact that the warrants could not be traded will presumably greatly limit the demand for them. “You are talking about a very idiosyncratic contract,” notes Myron Scholes, one of Black-Scholes’s Nobel laureate creators. “The Cisco management team must know a lot more about HR [human resources] at Cisco than the outside investors. Due to that, [investors] would probably insist on a large discount.”

Many thanks to Jeffrey for providing Lowenstein’s discussion.