Employee stock option valuation in mergers and acquisitions: Story of lost time values

Abstract

PURPOSE OF THE STUDY. The purpose of the study is to show how target employee stock options (ESOs) are valued in mergers and acquisitions, and to answer whether the possibility of company being bought should affect the stock option values. I also investigate whether the valuation methods used in transactions retain the total value of ESOs including both the intrinsic and the time value components, what factors determine the choice of valuation method, and what are the implications of different methods to the option valuation.

DATA. Data set consists of option valuation method observations in mergers and acquisitions in 2008 and 2009, in which the target is publicly listed on either NYSE or Nasdaq. Total number of transactions in the sample is 381, and the number of option valuation method observations is 316 after excluding observations with no information available.

RESULTS. Findings of the study show that two main valuation methods emerge. Usually, target option holders receive the intrinsic value of options (the offer value over the exercise price) and the options are forfeited, or then the options are converted to new options of the acquirer or the surviving corporation. Options are more likely to be converted if transaction is paid in stock, when the transaction value is high, and when the acquirer is publicly listed or based in the US.

Converting options retains the time value of options and therefore generally retains or increases the option value. Paying the intrinsic value and forfeiting options may result to either lower or higher option value, and the outcome is mainly driven by the takeover premium and option moneyness. For instance, in 21% of the cases when the intrinsic value is paid, the strike price of all options exceeds the offer value and the payoff to the option holders equals to zero. Findings suggest that ESO valuation in corporate transactions can have a significant effect on option value and therefore it should be in incorporated into the valuation models.