Estimation of Employee Stock Option Exercise Rates and Firm Cost

Abstract

This paper is the first to perform a comprehensive estimation of employee stock option ex- ercise behavior and option cost to firms. We develop a GMM-based methodology, robust to heteroskedasticity and correlation across exercises, for estimating the rate of voluntary option exercise as a function of the stock price path and of various firm and option holder character- istics. We use it to estimate an exercise function for a sample of 1.3 million employee-option grants to 530,266 employees at 103 publicly-traded firms between 1981–2009. We use the estimated exercise functions in a simulation based valuation model to analyze the effect of different firm and option characteristics on option value, and show that the Black-Scholes- based methods used in practice can create systematic biases.