Understanding the Black Scholes Formula and Present Factors

January 21, 2019 Shareworks Marketing

When it comes time for a company to assign formal values to its equity compensation awards, many choose to use the Black-Scholes option pricing model. Of course, if you’ve ever taken a look at the Black-Scholes model, it can be confusing and maybe even overwhelming. That’s why we’ve put together this high-level overview private companies can use to better understand the Black-Scholes formula and its various inputs.

First things first: ASC 718 & SAB 107/110

Before you take out your calculator, it is wise to understand the required accounting standards. 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 toward public companies rather than private. As a result, private companies often need to rely on both ASC 718 and Securities and Exchange Commission (SEC) staff accounting bulletin SAB 107/110 for guidance.

Six inputs required for the Black-Scholes option pricing model

Next, here are the six inputs required for the Black-Scholes option pricing model that must be determined. We’ll break them into two types:

  1. Present factors (set amounts that do not require estimates)
    • The option price
    • Market price
    • Interest rate
  2. Forecasting factors (amounts that must be estimated)
    • Expected life
    • Volatility
    • Dividend yield.

Present factors overview

Let’s dive into the Black-Scholes formula’s present factors. For the purposes of the example below, imagine a hypothetical example where a company just issued a new employee a grant of 10,000 stock options that will vest in three years and expire in seven years.

Option price

The option price – also known as the exercise price, strike price or grant price – is the cost that an 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.

Market price (grant date fair market value)

This input is the grant date value of the underlying security that the option converts into – again, usually a company’s common stock. Publicly traded companies typically use the grant date closing price. Private companies, however, are required to have their stock professionally valued in compliance with the standard in Internal Revenue Code Section 409A. Typically, a company  works with an analytics team, like Shareworks Valuation Services, to calculate the initial value and have it updated on a regular basis – typically annually, but this changes as the company grows, raises new rounds of funding or gets closer to a corporate transaction or liquidity event.

Interest rate

To determine this input, start with the interest rate on risk-free securities (e.g. 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. Why five years? We explain that here with information on Black-Scholes model forecasting factors.

Has your company recently raised a new round of funding, undergone a liquidity event or other corporate action? Reach out to us.

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