Employee stock options are similar in nature to call options. They award the right to buy an asset (in this case, the share), for a predetermined term (determined either as a fixed amount or calculated by using a formula). As mentioned above, options are often granted at an exercise price that is similar to the price of the share at the time the option is awarded. The transfer of the options to others is almost always restricted, they cannot be sold to third parties, and they must be exercised within certain time frames, usually less than ten years from the date of the grant. They are usually subject to a long vesting period, and in most cases are not protected against dilution resulting from the allotment of shares to different investors.

The customary model for option valuation is the Binomial Model, of which the Black and Scholes model is one version. This model, which was originally developed to price traded stock options that were not allotted by the company, provides in principle a good yardstick for valuating options, and its formula may be adjusted to account for the various terms of the options. In the case of employee stock options, the value of the options is substantially lower than that produced by the model without adjustments, due to the multitude of limitations imposed on them, mostly related to limitations on their transferability. According to various estimates, their value is on average less than one-half that produced by the Black-Scholes model.

The model prices the value of options on the basis of the following elements: the price of the share at the time of allotment, the risk-free interest rate at that time, the life span of the option (namely, the period in which the options may be exercised), the share's volatility (in the case of a closely held company, the data of similar listed companies are used after adjusting for the lower liquidity of the shares) and the dividend yield of the shares.

Paradoxically, the higher the share's volatility, the higher the value of the option. The reason for this is that the option holder will exercise it only if the price of the share is higher than the exercise price. Consequently, a higher volatility that may translate into a higher price per share (or a lower price per share, although this eventuality is irrelevant to the exercise of the option) increases the range of profits to the option holder. Obviously, this is not to say that the value of the option is not affected by a decline in the price of the share—the value of options drops faster than the price of the share when the latter declines.

In order to get a general idea of the value of options, let us look, for example, at an option that is exercisable over a period of ten years, with an exercise price identical to the price of the share at the time of awarding of the option. The annual share volatility is assumed to be 30% (which is more than the average volatility of large American companies, but is similar to a typical volatility of shares of established high tech companies) and no dividend yield. In such a case, the value of the option would be approximately 55% of the current value of the share.

The dividend yield has a dramatic impact on option holders since they are usually not compensated for dividend distributions, which signify the transfer of financial resources from the company to its other shareholders. Startups usually do not pay dividends, and therefore the significance of dividend payments is lower.

Responses to a Fall in Stock Values

As mentioned above, options became a material component of many compensation packages. Consequently, when stock prices fell, particularly in the second half of the year 2000 and during 2001, the value of such options declined dramatically. A plunge in stock prices has a severe effect on employee morale and on their loyalty to the company, since there is no point in waiting for an option to vest and become exercisable if the exercise price is higher than the market price of the share. In the past, companies in such situations have repriced the exercise price of the options, for instance, by issuing additional options with lower exercise prices to revive the motivational power of the options. This was done by the computer company Apple, the software company Netscape, and the electronic bank E-Trade. However, since the repricing of options infuriates investors in public companies, only a small portion of companies whose shares collapse indeed reprice their options. Repricing may cause severe accounting problems. The current rules require that if the exercise price of an option is amended downward, any upward change in the price of the share after the repricing be recorded as an expense in the financial statements. This has resulted in a smaller occurrence of repricing in the latest crisis compared to the scope of the phenomenon in the past. An alternative is for the company to cancel the exiting options and issue new options after more than six months, based on the prevailing market price at that point. Reporting rules do not customarily require the recording of the repricing value as an expense, since, in the interim, employees are exposed to potential changes in market prices.