The widespread adoption (and abuse) of employee stock options, advances in valuation technology, and new tax (Section 409A) and financial accounting (FAS 123R) rules have caused appraisers and company managers to focus much attention on the technical aspects of option valuation. That’s as it should be. Section 409A sets a minimum exercise price to avoid the imputation of employee income taxes. FAS 123R deals with allocating equity value to the various classes of equity securities.
But I wonder if management in particular is missing a crucial point. The overriding purpose of issuing stock options is to motivate grantees to increase the value of the company by giving them a proverbial piece of the action.
I find it helpful to think of stock options as a high jump. If you jump over the bar, you win. If you don’t, you lose. If you start out setting the bar four feet high, just about everyone will clear it. This is not very motivating. If you set the bar at eight feet, nobody except a world-class jumper has a chance. This is also not very motivating.
The real question managers ought to consider in setting option exercise prices (how high the bar is) should have to do with motivating employees, not with minimizing taxes or allocating equity value. Only a very few managements seem to address this issue directly.
We can help them by modeling different scenarios (financial forecasts and option values given different exercise prices), but in the end it is up to them, not us, to address this issue.