The Importance of Behavioral Factors in the Exercise and Valuation of Employee Stock Options∗

Options are a major component of corporate compensation and accounting methods significantly affect allocations, yet valuation remains a challenge. We develop the first empirical model of employee exercise suitable for valuation, and estimate the exercise rate as a function of option, stock, firm and employee characteristics in a large sample of all employee exercises at over 100 firms. These characteristics significantly affect exercise behavior and cost, in ways that Black-Scholes approximations used in practice fail to capture, and previous studies have failed to quantify. For example, vesting-date notifications trigger exercises, so vesting structure has a very important impact on option value: Increasing vesting date frequency from annually to monthly reduces option value by 20%. Men exercise faster than women, reducing option value by 2–3%. Top employees exercise faster than lower-ranked employees, reducing option value by 3–4%. Consistent with employee option theory, wealthier employees exercise later, whereas employees with more option risk exercise earlier. Finally, we develop an analytic approximation to our valuation method that is much more accurate and easy to use than the methods currently used in practice. JEL classification: G14.