If your company is like most, once you’ve decided to assign a formal value to your equity compensation awards, you’re probably going to use the Black-Scholes option pricing model. Of course, if you’ve ever taken a look at the Black-Scholes formula, it can seem a little daunting. That’s why we’ve put together this high-level primer private companies can use to figure out what inputs to plug into the formula.
First things first: ASC 718 & SAB 107/110
Before you whip out your calculator, you’ll need to do a little accounting due diligence. This starts by understanding which accounting standards you need to follow. While ASC 718 is the standard that the Financial Accounting Standards Board (FASB) uses to govern accounting for share-based plans, it’s geared more to public companies than private ones. As a result, private companies need to rely on both ASC 718 and Securities and Exchange Commission (SEC) staff accounting bulletin SAB 107/110 for guidance.
Next, you’ll determine the six inputs required for the Black-Scholes option pricing model. We’ll break them into two types:
- Present factors –The option price, stock price, and interest rate are set amounts and do not require an estimate.
- Forecasting factors – Expected life, volatility, and dividend yield require the company to estimate what these amounts will be.
Let’s start with the present factors. To come up with them, let’s imagine you just issued a new employee a grant of 10,000 stock options that will vest in three years and expire in seven years. Ready? Let’s go.
The option price – also known as the exercise price, strike price or grant price – is the cost your employee will pay per share at exercise. This input is pretty straightforward, usually 100% of your company’s common stock price on the grant date.
Stock price (grant date fair market value)
This input is the grant date value of the underlying security that the option converts into – again, usually your company’s common stock. Publicly traded companies typically use the grant date closing price. Private companies, though, need to have their stock professionally valued in compliance with the standard in Internal Revenue Code Section 409A. Generally, you’ll work with an analytics team (Shareworks Valuation Services can help!) to calculate the initial value and have it updated on a regular basis – annually for very early stage companies and quarterly as the company grows or gets closer to a corporate transaction or liquidity event.
To determine this input you’ll look at the interest rate on risk-free securities (i.e. government bonds) posted by the US Treasury on the date of your grant. These interest rates are generally listed for one, two, three, five, seven and ten year bonds. The rate you use is the one that matches the expected term of your option. For our example, where the expected term is five years, you would use the interest rate listed on five-year bonds.
At this time, you may be thinking that this Black-Scholes thing is easier than you expected. In our next installment, we’ll consider the three forecasting factors, which can be somewhat trickier. So, stay tuned. And in the meantime, be sure to reach out if you have any questions.