3 Things You Need to Know When Valuing Employee Stock Options

So, you’ve just been offered a job and the salary package includes an employee stock option plan that sounds generous.

Before jumping into it, it is crucial you understand how stocks will affect your net worth, and to do that you need to know their value.

When it comes to deferred compensation, how do you know what they’re going to be worth five years from now?

This is an issue that is increasingly more common as employers look towards stock options as a way to lure and retain employees. After all, stock options only require a commitment of an employee’s time, not their money – what’s there to lose?

The first thing you need to understand is what employee stock options are.

1. What are they?

A stock option is a financial instrument that allows employees to buy or sell shares in the company at a fixed or specific price (the “exercise price” or the “strike price”). Options can either be:

• “Call options,” which gives the holder the right to buy shares at the exercise price; or
• “Put options,” which gives the holder the right to sell shares at the exercise price.

As a part of employee compensation packages, companies sometimes award call options to employees.

For example, if Robert has 100 call options of his employer’s shares with an exercise price of $14, he has the right to exercise his options and buy 100 shares of his employer’s shares at a total cost of $1,400, regardless of the actual price of his employer’s shares.

Once you understand what they are, you can start to break down why stock options, specifically call options, are used.

2. Why Do Companies Use Call Options as Compensation?

A major reason for providing call options as a part of compensation is that it aligns the motivation between employees and business owners.  In a corporate environment, one of the main motivations of a business owner is to maximize future profits and thereby increase the value of the company’s shares. This strategy works to incentivize employees because they directly benefit when their call options become more valuable as the company’s overall value increases.

Lastly, to understand why, it’s important to understand why call options have value.

3. Why Do Call Options Have Value?

There are many intricate methods to determine the value of a call option, but a simple illustration may be helpful.

Consider Robert’s situation again, where he has 100 call options for his employer’s shares with an exercise price of $14. If his employer’s shares are currently trading at $15 per share and Robert has the option to purchase them at $14 per share, Robert may want to consider exercising his options as the options are considered to be “in the money.” By exercising his options, he would be able to purchase the shares at $14 each (even though they’re actually worth $15 each). He could then sell the shares for $15 each, earning an instant profit of $1 per share.

Alternatively, if his employer’s shares are trading at $13 per share and Robert has the option to purchase them at $14 per share, it would not make sense to exercise his options as they are now considered to be “out of the money.” He would be better off to buy his employer’s shares directly at $13 per share, rather than exercising his options and paying $14 per share.

Putting it all together

The value of a call option, therefore, is essentially determined by both the likelihood that the option will be in the money, and the depth to which it will be in the money. Key determinants include the following:

Although these guidelines are an excellent starting point, determining the exact value of employee stock options is an intricate process. At Davis Martindale, we are experienced in providing employee stock options and other deferred compensation arrangements valuation reports. If you need a valuation of your stock options, the experts at Davis Martindale would love to work with you.