Granting non‐tradable stock options: the opportunity costs for shareholders and employees

Purpose - Firms grant non‐tradable stock options to their employees as an incentive device. Is the cost of issuing these options equal to the amount the company would receive if it sold the same options to outside investors? The evaluation of this cost is the main objective of this article. The options granted to employees are not tradable, due to the incentive scheme to which they are related. A non‐tradable option is an asset that cannot be evaluated with standard Black‐Scholes formulas. Design/methodology/approach - The article adopts standard option pricing, introducing some corrections since Black‐Scholes formulae do not apply. The new formulae show the dependence of option values on how diversified both the employees and the firm are; and the influence that the incentive to work by employees has on the stock price. Findings - Once stock options satisfy a participation constraint, they can be granted to employees who stand to gain. However, they do not provide a net benefit in all circumstances to shareholders since they may gain, break even, or lose. Even though in many cases stock options may appear to be an inefficient way to stimulate work effort, in start‐ups and entrepreneurial firms they turn out to be quite beneficial. Practical implications - Stock option opportunity costs have to be valued taking into account the extent of their non‐tradability and the incentive they provide to employees. Originality/value - The article introduces a correction for valuing non‐tradable stock options. This permits us to measure properly the opportunity cost of stock options, which is often mis‐specified.