Employee stock options with performance conditions: do commonly used valuation heuristics work?

Abstract

Valuation heuristics are widely used to value traditional time vesting option plans. This study analyses if these heuristics also qualify for valuing performance vesting plans. We examine performance conditions tied to the underlying stock, the stock's performance relative to a stock index, and an earnings measure. The differences between the approximated option values and the values assuming optimal exercise are overall smaller with the performance conditions than without them. In particular, this result holds when the heuristic exercise assumptions are based on the case without performance conditions, which is a considerable simplification in practice.