Taxation and the Value of Employee Stock Options

Purpose – This paper aims to derive firm value implications for various kinds of employee stock options (ESOs) in a framework that considers uncertainty, non‐diversification and the US statutory tax treatment. Design/methodology/approach – The authors extend the analysis of ESOs from the case of perfect capital markets to two cases of imperfect capital markets using the Benninga‐Helmantel‐Sarig framework. Findings – It is found that ESOs are inferior to cash compensation and that the degree of option inferiority depends on employee diversification. In addition, incentive stock options (ISOs) are generally inferior to non‐qualified stock options (NSOs). This relative profitability of the NSO versus ISO increases as market imperfections are added. The authors also find that in general firm hedging of ESOs is suboptimal. Originality/value – The paper highlights the firm value of employee stock options.