Estimating the "fair value" of employee stock options with expected early exercise

The FASB recently issued an exposure draft that proposes that firms recognize as compensation expense the estimated fair value of their employee stock option (ESO) grants. The key problem in obtaining value estimates for ESOs is that employees may favor early exercise of ESOs due to restrictions placed on ESO transferability. Since the problem of potential early exercise does not apply to traded options, standard option valuation models developed for traded stock options cannot be applied directly to ESOs. Consequently, the issue of uncertain early exercise is among the most conceptually challenging in valuing ESOs. To address this problem of early exercise, the FASB proposes that firms should base the valuation on the expected rather than the full contract term of the ESOs. A study evaluates the valuation implications of this approach. Specifically, the study provides theoretical as well as empirical evidence that simply substituting the expected term of the ESOs for the actual contract time in standard option valuation models will most likely result in overstating the fair value to the firm of granting ESOs. A relatively simple adjustment is proposed that is less likely to produce such overstatement while still taking into account all the parameters that give value to ESOs.