Employee Stock Options

This paper considers the optimal exercise policy for employee stock options taking into account the tax incidence of exercise on both the employee and employer as well as the employee’s risk preferences. A recursive algorithm that determines the optimal exercise policy and option value is presented. The employee strictly prefers to exercise options before maturity under certain conditions on risk aversion, tax status, and information. The paper explains whether and when (i) additional payments to the employee from employer improve the after-tax welfare of the employer, and (ii) options are more or less tax efficient than a bonus. The paper documents two instances in which financial accounting rules appear to influence the adoption and form of tax inducements.