Employee stock options in compensation agreements: A financing explanation

We develop a model for the use of stock options in compensation agreements based on a financing explanation. Our model is consistent with the extensive use of options for non-executive employees. Simulation results from our model show an optimal use of options of about 9.3% of total compensation for a non-executive employee with a compensation of US$50,000. Finding an optimal level of options as part of compensation in this context requires a balancing of two opposing factors-the benefit of a lower capital issuance cost versus a higher compensation cost as a result of the discount that an employee places on options because of an undiversified position.