Early exercise

The two questions:

are fundamental to understanding and increasing the benefits to employers and employees from stock option compensation.

To an employer, stock options are part of a compensation program (also including salary, pension, bonuses, and fringe benefits) that fosters employee loyalty and productivity. Both the cost of the compensation package to the employer and the incentives for loyalty and productivity created for employees depend on when employees exercise their options. Once an employee has exercised their options and sold all the stock acquired on exercise of the options, then there may be no incentives at all. To prevent this, many employers grant employees new options every year and require a specified time to pass before the options vest, or become exercisable. Consequently, employees commonly hold unexercised stock options from several different grants, even if they exercise every option as soon as it vests.

Options from different grants have different strike prices and expiration dates. Choosing the best time to exercise each grant of options so as to maximize the benefits to the employee is a very complicated problem. Since the employee cannot trade freely in either the option or the underlying stock, the value of the option to the employee, and the optimal exercise policy do not follow the usual arguments that apply to exchange-traded options. This article summarizes some recent research findings related to this problem, and suggests some analysis employees can conduct before deciding whether to exercise.

Research findings

The typical employee exercises his grant in a few large transactions. We found that employees frequently exercise their options years before expiration. Increases in stock price volatility, increases in the ratio of the share price to the option strike price, and a shorter time to option expiration are associated with increases in exercise. Vesting schedules are also significant in explaining exercise. Many employees exercise the maximum permissible number of options shortly after the first vesting date. Some employees wait past this first vesting date, but then exercise all available options soon after a subsequent vesting date. Much exercise takes place well before expiration.

Since the results are generally similar across sample companies, employee exercise behavior appears to be consistent over the range of factors represented in the data, but the great variation in individual employee decision points to the importance of individual employees' personal circumstances.

Early exercise (i.e., exercise before the expiration of the option) resulted in some employees sacrificing a large fraction of their options' potential value. In our sample, we found the value sacrificed to be greatest in the large public companies, and smallest for start-up companies that issued options with very low strike prices to employees before going public.


Reasons for early exercise

Since the employee stock options are non-transferable, employees cannot sell them. In most cases, the only way an employee can get cash from options is by exercising them. Employees often exercise early because they need cash or because they prefer to hold a less risky, more diversified portfolio of assets. Economists call an urgent need for cash a liquidity Need, and the desire to avoid risky payoffs risk aversion.

Besides liquidity needs and risk aversion, other reasons for early exercise include dividend distributions (because these distributions are received by shareholders, but not option holders) and termination of employment (because options contracts often specify that an employee's options are cancelled shortly after the employee leaves the firm). Additionally, changes in tax rates may create situations in which early exercise increases net-of-tax cash flows. Finally, employees may exercise because they know adverse information about the company and want to liquidate their holdings before this information gets out and the stock price is driven down.

Read more about: