Electronic copy available at: http://ssrn.com/abstract=905280 Electronic copy available at: http://ssrn.com/abstract=905280 Timing of Employee Stock Option Exercises and the Cost of Stock Option Grants Christopher S. Armstrong Alan D. Jagolinzer David F. Larcker Stanford University Graduate School of Business 518 Memorial Way Stanford, CA 94305-5015 Revised June 1, 2007 Abstract: This study examines how executives’ and lower-level employees’ option exercise behavior affects firms’ stock option grant cost estimates. Prior research suggests that option grant cost estimates are not materially different when calculated a using utility-based model or a risk- neutral model adjusted for historical exercise rates. This study shows, however, that estimates of exercise times are significantly improved when the model accounts for behavioral and economic determinants of option exercise such as the attainment of performance benchmarks, recent vesting, the intrinsic value of an employee’s option portfolio, and employee rank. Hazard analysis of all executive and employee option grants within a proprietary sample of firms yields lower out-of-sample exercise timing prediction errors relative to utility-based models and estimates using historical exercise patterns. More importantly, option cost estimates are materially different when improved estimates of exercise times are used, which may have implications for financial reporting. JEL Classification: C34, C41, J33, M52 Keywords: Option expense; employee option exercise; SFAS 123; stock option cost; survival analysis We would like to thank Terry Adamson, James Lecher, and Philip Peterson (Aon Consulting) and Sean Scrol (Valtrinsic LLC) for their considerable help with this project. We also thank David Aboody, Mary Barth, William Beaver, John Core, George Foster, Ian Gow, Chip Heath, Leslie Hodder, and workshop participants at Indiana University, the Pennsylvania State University 2006 Accounting Research Conference, and the Stanford University 2006 Summer Accounting Research Camp for valuable comments.