Recently, my one-year-old started to walk and watching him do this for the first time was amazing. As I watched him over the past year learn how to roll over, and then crawl, and then walk, I realized that learning how to walk is very difficult. In a similar way, as I have helped clients with FAS 123R reporting (now ASC Topic 718) over the past three years, I’ve realized that learning FAS 123R is also very difficult.

As discussed in my blog post 5 Ways to Perform Year-End Equity Management and FAS 123R Work Faster, busy CFO’s want to learn to “walk” as quickly as possible, so they can easily generate the company’s FAS 123R disclosures. Unfortunately, if you are new to FAS 123R, you need to learn to “crawl” before you can learn to walk. With the goal of creating the financial statement disclosures, I’ll cover three areas a typical privately held, venture-backed company needs to learn to value, expense and report plain vanilla option grants. I’m not going to get into complicated definitions for any of these. Instead, I’m going to stick to the FAS 123R basics to help you take the first few steps toward understanding FAS 123R better (using my son’s first few steps as the metaphor):

- Learn to Roll Over – Value the option grants
- Learn to Crawl – Expense the option grants
- Learn to Walk – Report the expense and required disclosures

**Learn to Roll Over – Valuing the Option Grant**

The first and most basic building block you need as part of generating your FAS 123R disclosures is to value each stock option grant. Private companies will use the Black-Scholes model to calculate the fair value of their option grants. In order to calculate the fair value, you will need the following six variables. While an equity management system can do all of the FAS 123R calculations work for you, it is still important to understand how the FAS 123R disclosures are generated.

**Fair Market Value**– This is the value of your underlying stock on the date of grant and is typically determined as part of a 409A valuation.**Exercise Price**– This is typically the same as your FMV.**Expected Term**– You need to calculate your expected term. There are several ways to do this, but assuming you are a private company with little historical information, FASB gives us a formula under SAB 107, as extended by SAB 110.The formula is: (Weighted Average Vesting + Contract Term)/2.

- Contract Term: This is simply the life of the grant. If it is a 10-year grant, then contract term = 10. If it is a 7-year grant, then contract term = 7.
- Weighted Average Vesting: This measures the amount of time from date of grant to each vesting tranche and weighs it based on the number of shares vesting. I’ve included a sample of this in Two Step Software’s set of free Black-Scholes Calculators.

**Interest Rate**– In order to determine the interest rate to use for your option grant, you need to do the following:

- Go to the Federal Reserve Board site and download the Treasury Constant Maturities.
- This gives you forward looking rates for 1, 2, 3, 5, 7 and 10 years.
- Match the expected term you generated to the year. That gives you the interest rate to use in your Black-Scholes calculation. If your expected term is 5, use the 5 year rate. If your expected term is 6, you need to average the rates for years 5 and 7 to get the appropriate rate for 6 years.

**Volatility**– In order to determine your historical volatility, you need to do the following:

- Determine your company’s set of public peer companies.
- Download the stock prices for each of the peer companies by entering their stock symbol at Yahoo Finance.
- Enter these stock symbols into a volatility calculator. You can download Two Step Software’s free FAS 123R volatility calculator.
- Enter the expected term.
- You now have a volatility that can be used in calculating fair value using Black-Scholes.

**Dividend Rate**– A typical private company does not distribute dividends, so this is normally 0.

As soon as you have all of these inputs, you can plug the values into the Black-Scholes formula to come up with the fair value per share for an option grant.

Complicated? Yes, I know. But to help you out, I’ve included an Excel spreadsheet-based calculator as part of our Black-Scholes Calculators below that you can use with the variables we drilled down on above to generate your fair value per share using the Black-Scholes calculation.

Download Two Step Software’s set of free Black-Scholes Calculators for help in generating your weighted-average vesting term, volatility, interest rate, and fair value per share. In the future, if you want to avoid the hassle of doing all these calculations for your option grants using spreadsheets, take a look at a demo of Two Step Software’s consolidated, online equity management system.

Check back next week to learn how to “crawl” before you “walk” and see how to expense the fair value of the option grant over the requisite service period.

And if you have any questions about the FAS 123R variables, feel free to contact me or post them to the comments below.

Nice work. A basic understanding is essential. I’m fairly well versed in this stuff, so i’ll look forward to more detailed analysis from you.

Matt, thanks for the feedback on the post. Looking forward to hearing from you on future posts.

Nice explanation. about the interest rate, shouldn’t we use an annualized number instead of the rate of the matched option maturity?

I do primarily SEC work and virtually all companies use the fed discount rate. One can argue some companies can’t borrow at such a low rate, but the discount rate typically has the least impact of all the assumptions.

Dealing with FAS123r at work is challenging enough. Try learning it on your own in between jobs! Thanks Jeremy! If I read it enough, it’s bound to make sense, right?

Taeho, I’m with you on that. Definitely, the more you read, it will eventually come into focus.

A good summary of Black-Scholes model. Just one thing to point out: risk free rate using the rates from the Fed is good for academic purposes. For corporate valuations, Zero Coupon Rates (per FAS123R) should be used which is awailable on WSJ, or by another company named Option123 (http://www.option123.com/riskfree).

Thanks Steve. Yes, FAS 123R does specify the use of the zero coupon rates for the risk-free rate. Saying that, auditors are accepting the fed discount rates especially for nonpublic companies. Since the risk-free rate has the least impact on the fair value, the difference between using the zero coupon and fed discount rates is usually small.

Pingback: FAS 123R – Part 3: FAS 123R Reporting Disclosures … Clarified | Two Step Software, Inc.

Pingback: FAS 123R – Part 2: Expensing Stock Options … Demystified | Two Step Software, Inc.

here is an online BS calculator

http://indoorworkbench.com/?financerisk/black-scholes-option-calculator.html