Why do employees like to be paid with Options?: A multi-period prospect theory approach*

- We conjecture that employee stock option issuance is driven by employee preference for options.
- Models based on employee overconfidence or prospect theory may explain this preference.
- We develop two dynamic, multiperiod models for valuing non-executive employee option grants.
- We cannot reconcile the use of options with overconfidence in an expected utility framework.
- We find support for a multiperiod prospect theory model, and employees also exercise early.

The use of options as compensation for non-executive employees is a puzzle. Standard, rational, valuation models show that the cost of issuing options is larger than the value placed on the options by employees. Existing explanations for this puzzle are based upon static models that ignore the considerable dynamic aspects of employee stock option pricing and exercise behavior. We develop dynamic, multiperiod models of employee preferences considering risk aversion, loss aversion, overconfidence and probability weighting to test possible explanations of the use of employee stock options. We find that a cumulative prospect theory model generates scenarios where employees would prefer options to either cash or equity payments, and also optimally exercise their options early. This is the only model where options are preferred and also optimally exercised early.