ABSTRACT
Many companies have been awarding employee stock options (ESOs) to managers and key employees for many years. You may be familiar with the back-dating of stock options scandal that emerged recently in some technology companies. Some companies may have engaged in the fraudulent practice of changing the characteristics of the employee options (time to expiry and strike price) when their stock prices fell and the options awarded to employees matured worthless. ESOs are similar to financial options with one unique difference: they are not traded and are typically exercised prematurely by the employees. As you know, it is never optimal to exercise an option prematurely if you can sell it. In the case of ESOs, holders may exercise them prematurely to diversify their portfolios or to create income. For many owners of the ESOs, a large percentage of their revenue and estate are tied to the prospects of the company for which they work, and diversification may become a strategic need. You may remember that many employees of Enron, who invested most of their 401(k) pension plan assets in Enron stock and owned ESOs on Enron stock, had a difficult time when Enron went bankrupt. There is no better wisdom than the importance of diversification in all areas of finance.
