Employee Stock Options: After the Dot-Coms

Misapplications of The Black-Scholes Model

One point often overlooked in lost stock options claims based on Black-Scholes valuation methodology is that the model assumes marketability of the option, yet the marketability of almost all employee stock options is restricted. Most of these stock option agreements contain language to the effect that the option is exercisable only by the employee during that employee's lifetime, or by the employee's personal representative in the event the employee dies. These plans expressly prohibit transfer of options. Unless this severe limit on marketability is taken into account, a Black-Scholes valuation of the employee's stock options will be significantly higher than warranted.

Another aspect often overlooked in employee stock option damages claims is the fact that options simply represent the right to buy the underlying stock. They do not compel the employee who exercises that right to sell the stock immediately, or at all. Nor does the option compel the employee to exercise the right to buy as soon as the option vests. Under most plans, employees with vested options are required to exercise the option within a short period of time ' usually 90 days after termination. Frequently, plaintiffs claim the difference in the stock price at the time of termination and a subsequently higher price of the stock.

For example, suppose that on termination, the plaintiff exercised 15,000 options with a strike price of $15 per share at the prevailing market price of $35 per share, making an instant profit of $300,000. The plaintiff at trial then claims that, but for the termination, he would have exercised 2 years later at a market-high $60 per share, and thus would have realized an additional $375,000.

This claim fails the logic test twice. The plaintiff was under no compulsion to sell the stock at the time of termination. He could have purchased the underlying stock and held it without missing out on subsequent rises in price. This claim also implies that the employee, had he not been terminated, would have known exactly when to exercise the option at the top of the market. Such pinpoint market timing is extremely rare.

Similar claims, made normally when the option may be out of the money, include a valuation of the option that assumes it would be exercised on the last possible day (ie, the 10th anniversary of the grant). One of the properties of the Black-Scholes model is that longer option duration indicates higher value. Besides ignoring possible blackout periods (times when the corporation does not allow employee stock options to be exercised), this assumption ignores academic studies on option exercise and portfolio management, which indicate that employees tend to hold options for 5 years, not 10.

Another area where options-damages claims are often overstated involves claims that the plaintiff would have, but for the termination, received options in the future. The assumption that the employer would have continued to grant options throughout the plaintiff's work life begs several questions. Employee stock options are discretionary, and almost all require specific stockholder approval. Similarly, almost all stock-option plans have 'sunset' provisions, whereby the plans are operative for a limited time. Thus, a claim that the plaintiff would have been granted options regularly assumes that the defendant corporation would continue to offer the options, that its shareholders and board of directors would continue to approve such plans, that the plaintiff would have continued to work for the defendant until retirement, that the plaintiff would have continued to be eligible, that the underlying industry is viable and will continue to be so, and that the defendant corporation's common stock will continue to increase in value. To further enhance the amount of prospective option values, some plaintiff economists will assume that the terminated employee, but for the termination, would have been promoted regularly by the defendant.

Finally, for not-yet-granted stock options, the Black-Scholes model can only give a speculative value, since several crucial variables must be projected, including the stock price on the day the future option is to be granted. Since the strike price of the option is generally set at the fair market value of the underlying stock on the date of the grant, an economist valuing loss of a not-yet-granted option would have to precisely predict that future stock price in order to apply the Black-Scholes model properly. This projection of future stock price is, necessarily, extremely speculative. The Black-Scholes model is an effective and useful tool in its place ' valuing marketable options actually in existence'but it is not an ideal tool for valuing options that do not yet exist.

Conclusion

The Black-Scholes model, as well as other options-pricing models, are widely accepted and extremely useful. However, to serve as useful tools in the estimation of economic damages stemming from lost employee stock options, their limitations must be evaluated and understood. Careful attention must be paid to the assumptions underlying the claim, including when the plaintiff has exercised the option and whether the defendant would have granted the option.

Dr. Brian Sullivan is a senior economist at the offices of the Center for Forensic Economic Studies in Philadelphia.

Employee stock option compensation, once the darling of the dot-com revolution, retains its popularity as an item of damages in wrongful termination matters. As wrongful termination claims mount, so do claims for economic damages involving stock options plans. Many of these reflect misconceptions over the nature of employee stock options, and questionable assumptions on the method of valuing the loss.

While the dot-com frenzy is over, shares in such industries as pharmaceuticals, consumer goods, home building, banking and finance, and certain electronic sectors continue to trade at relatively high levels. Thus, claims for damages stemming from lost stock options remain common in employment suits brought by employees who have been terminated by companies in these industries.

An employee stock option grants the employee the right, but not the obligation, to purchase common stock of the employer corporation during a specified period of time, for an agreed-upon price. Typically, the duration of an employee stock option is 10 years from the date of grant. As late as the mid-1990s, valuation of damages in claims involving employee stock options was a matter of projecting the price of the underlying stock, then making assumptions as to when the plaintiff would have exercised the options over the remainder of their term. This methodology gave way to the Black-Scholes Option-Pricing Model, as plaintiff economists gradually increased their sophistication. This model of valuation was developed by Fischer Black and Myron Scholes in the early 1970s. While the model enjoys an excellent pedigree ' Myron Scholes was awarded the Nobel Memorial Prize in Economic Sciences for his work on the theory of option valuation ' it is often misapplied in the employment-litigation setting.

Misapplications of The Black-Scholes Model

One point often overlooked in lost stock options claims based on Black-Scholes valuation methodology is that the model assumes marketability of the option, yet the marketability of almost all employee stock options is restricted. Most of these stock option agreements contain language to the effect that the option is exercisable only by the employee during that employee's lifetime, or by the employee's personal representative in the event the employee dies. These plans expressly prohibit transfer of options. Unless this severe limit on marketability is taken into account, a Black-Scholes valuation of the employee's stock options will be significantly higher than warranted.

Another aspect often overlooked in employee stock option damages claims is the fact that options simply represent the right to buy the underlying stock. They do not compel the employee who exercises that right to sell the stock immediately, or at all. Nor does the option compel the employee to exercise the right to buy as soon as the option vests. Under most plans, employees with vested options are required to exercise the option within a short period of time ' usually 90 days after termination. Frequently, plaintiffs claim the difference in the stock price at the time of termination and a subsequently higher price of the stock.

For example, suppose that on termination, the plaintiff exercised 15,000 options with a strike price of $15 per share at the prevailing market price of $35 per share, making an instant profit of $300,000. The plaintiff at trial then claims that, but for the termination, he would have exercised 2 years later at a market-high $60 per share, and thus would have realized an additional $375,000.

This claim fails the logic test twice. The plaintiff was under no compulsion to sell the stock at the time of termination. He could have purchased the underlying stock and held it without missing out on subsequent rises in price. This claim also implies that the employee, had he not been terminated, would have known exactly when to exercise the option at the top of the market. Such pinpoint market timing is extremely rare.

Similar claims, made normally when the option may be out of the money, include a valuation of the option that assumes it would be exercised on the last possible day (ie, the 10th anniversary of the grant). One of the properties of the Black-Scholes model is that longer option duration indicates higher value. Besides ignoring possible blackout periods (times when the corporation does not allow employee stock options to be exercised), this assumption ignores academic studies on option exercise and portfolio management, which indicate that employees tend to hold options for 5 years, not 10.

Another area where options-damages claims are often overstated involves claims that the plaintiff would have, but for the termination, received options in the future. The assumption that the employer would have continued to grant options throughout the plaintiff's work life begs several questions. Employee stock options are discretionary, and almost all require specific stockholder approval. Similarly, almost all stock-option plans have 'sunset' provisions, whereby the plans are operative for a limited time. Thus, a claim that the plaintiff would have been granted options regularly assumes that the defendant corporation would continue to offer the options, that its shareholders and board of directors would continue to approve such plans, that the plaintiff would have continued to work for the defendant until retirement, that the plaintiff would have continued to be eligible, that the underlying industry is viable and will continue to be so, and that the defendant corporation's common stock will continue to increase in value. To further enhance the amount of prospective option values, some plaintiff economists will assume that the terminated employee, but for the termination, would have been promoted regularly by the defendant.

Finally, for not-yet-granted stock options, the Black-Scholes model can only give a speculative value, since several crucial variables must be projected, including the stock price on the day the future option is to be granted. Since the strike price of the option is generally set at the fair market value of the underlying stock on the date of the grant, an economist valuing loss of a not-yet-granted option would have to precisely predict that future stock price in order to apply the Black-Scholes model properly. This projection of future stock price is, necessarily, extremely speculative. The Black-Scholes model is an effective and useful tool in its place ' valuing marketable options actually in existence'but it is not an ideal tool for valuing options that do not yet exist.

Conclusion

The Black-Scholes model, as well as other options-pricing models, are widely accepted and extremely useful. However, to serve as useful tools in the estimation of economic damages stemming from lost employee stock options, their limitations must be evaluated and understood. Careful attention must be paid to the assumptions underlying the claim, including when the plaintiff has exercised the option and whether the defendant would have granted the option.

Dr. Brian Sullivan is a senior economist at the offices of the Center for Forensic Economic Studies in Philadelphia.