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Employee Stock Options

Employee or executive stock options (ESOs for short) are call options granted by a company to an employee on the stock of the company. These options are part of the remuneration package of the employee. However, they differ from ordinary options in at least one crucial way: they cannot be transferred, and in the event of the employee leaving the company, they are forfeited.

They are a sweetener for the employee: they encourage him or her to remain an employee, and they encourage him or her to work towards an increase in the financial health of the company, which will translate into an increased share price, and eventual increased wealth of the employee.

A very brief history of valuation questions

Until the birth of option pricing algorithms in the 1970s the common wisdom concerning ESOs was that they were not an expense because there were no cash flow implications for the firm. The first valuation methodology to be introduced was that options should be expensed at their intrinsic value on grant date. Provided that these options were granted at the money, which was typical, there would be no profit and loss or bottom line effect.