As noted in my recent blog posts, helping busy CFO’s learn how to generate the disclosure requirements of FAS 123R (now ASC Topic 718) and the two prior steps described below (valuation and amortization) reminds me a little of watching my one-year old son learn to take one step at a time. Because the primary goal of equity compensation reporting is creating the requisite financial statement disclosures, let’s continue with the third and final step a typical, privately-held, venture-backed company needs to understand to properly report equity compensation expense related to “plain vanilla” stock option grants. In case you are more advanced, please note that this article addresses the basics of FAS 123R.

For background reference, note the previous blog articles Part 1 and Part 2 of this 3-part series:

1. Part 1: Valuation and Black-Scholes Variables
2. Part 2: Expensing Stock Options
3. Part 3: FAS 123R Reporting Disclosures

Learning to Walk – Reporting the Expense and Related Disclosures

Now that we’ve learned to generate the fair value of an option grant using the Black-Scholes formula and how to amortize the fair value of an option grant over the requisite service period, we are now able to generate the requisite financial statement disclosures.

When working with plain-vanilla option grants, at a minimum, you will need to report these disclosures relating to your option valuation and expensing. These disclosures are now described in detail in ASC Topic 718-10-50. Under FAS 123R, you would find this information in Paragraph A240.

When looking at these disclosures, I like to break it down into three sections.

Section 1 – Valuation Summary

For the options granted in the current reporting period, you need to disclose the “range” and “weighted average” values for certain variables used in the Black-Scholes formula: volatility, interest rate, expected term, and dividend rate.

1. Range - To determine the range for each variable, you need to disclose the lowest value and highest value used for each. For instance, if a 20% volatility was the lowest value you used when determining fair value for the options granted in the reporting period and a 30% volatility was the highest value for the same period, the range you would disclose would be 20%-30%.
2. Weighted Average - To determine the weighted average for each variable, you need to “weight” each variable based on the number of shares granted at each value. The total number of shares granted is then divided by the sum of the weights to end up at the weighted average. For instance, if there is one grant for 1,000 shares with a 25% volatility and another grant for 500 shares with a 30% volatility, the weighted average volatility would be: (25*1,000) + (30*500)/1,500 = 26.67%.

When you disclose the range and weighted average values for each of the four Black-Scholes variables (volatility, interest rate, expected term, and dividend rate), as well as the range and weighted average values for fair value per share, you will be disclosing a total of 10 values in the valuation summary section.

Section 2 – Option Activity

For option activity in the current reporting period, you need to disclose the number of options outstanding at the beginning of the period, the option activity during the period, and several numbers related to the end of the period. The requisite disclosures breakdown as follows:

1. Total Outstanding at the start of the period – This is the total number of options outstanding as of the beginning of the period. If the reporting period is 1/1/2009 – 12/31/2009, this is the total number of options outstanding at the end of the day on 12/31/2008. The number outstanding at the start of the period will be: Total Granted – Exercises – Forfeitures – Expirations.
2. Grants during the period - This is the total number of options granted during the period, even if those grants were cancelled during the period.
3. Exercises during the period - This is the total number of options exercised during the period.
4. Forfeitures during the period - This is the total number of options cancelled during the period prior to vesting.
5. Expirations during the period - This is the total number of options cancelled during the period that were vested.
6. Total Outstanding at end of the period – This is the total number of options outstanding at the end of the period. The Total Outstanding at the end of the period is: Total Outstanding (at start) + Grants – Exercises – Forfeitures – Expirations.
7. Total Exercisable at end of the period – This is the total number of options that are exercisable at the end of the period. The Total Exercisable at the end of the period is: the number of options that have vested – the number of options that have been exercised for outstanding option grants.
8. Total Unvested at end of the period - This is the total number of options that have not yet vested at the end of the period. The Total Unvested at end of the period is: the number of outstanding options less the number of those options that have vested.
9. Total Vested or Expected to Vest at end of the period – The Total Vested or Expected to Vest at end of the period is: the sum of the number vested + the number expected to vest.

1. Total Vested - The number vested = the number that are exercisable at the end of the period (Item 7 above). You don’t use the number “vested” here, because it is possible that a portion of the vested shares have been exercised. You want to look only at the number of vested shares that can be exercised at the end of the period.
2. Expected to Vest - The number “expected to vest” is the number that is “projected to vest” at the end of the period. This value is the number of shares that are outstanding but have not yet vested at the end of the period (Item 8 above) after applying the annualized forfeiture rate, as described in the Part 2 article that discusses how to expense option grants.

For each of these nine disclosures, you also need to disclose the weighted average exercise price. For example, if there was an option granted for 1,000 shares at an exercise price of $2 and another option granted for 1,000 shares at an exercise price of $3 during the year, the weighted average exercise price for the number granted during the period (Item 2 above) would be: (1,000*2) + (1,000*3)/2000 = $2.5. Therefore, for each of these disclosures, you need to look at each individual grant, exercise, or cancellation that goes into the calculation and calculate the weighted average exercise price. A standard formula for weighted average exercise price for each item above could be expressed: (SUM(Disclosure Item for that grant * Exercise Price for that grant) for all option grants used in the Disclosure Item)/SUM of that Disclosure Item.

For disclosures 6-9, you also need to disclose the weighted average remaining contract term. For this calculation, you must first determine the remaining contract term for each option and then apply a weighted average based on the number of shares. The remaining contract term is calculated for each option by taking the number of days left between the reporting period end date and the date of expiration for that grant and dividing by 365 (because the value is disclosed as a number of years). A standard formula for weighted average remaining contract term for each item above could be expressed: (SUM(Disclosure Item for that grant * Remaining Contract Term for that grant) for all option grants used in the Disclosure Item)/SUM of that Disclosure Item.

For disclosures 6-9, you may also need to disclose the aggregate intrinsic value. Intrinsic value is the difference between the fair market value at the end of the reporting period and the exercise price of the option. Aggregate intrinsic value is the total of the intrinsic value for all the options included in the calculation for the disclosure item for the current reporting period. This value is not always required for privately-held companies because for many the fair market value changes infrequently. However, if you have the data, you may choose to include it. A standard formula for aggregate intrinsic value for each item above could be expressed: SUM(Disclosure Item * (Fair Market Value on Reporting Period End Date – Exercise Price for that Grant)) for all option grants used in the Disclosure Item. For instance, assume the fair market value of an option on the reporting period end date is $3. Then, assume there is an option grant for 1,000 shares outstanding at an exercise price of $2 and another option grant for 500 options outstanding at an exercise price of $1. The aggregate intrinsic value would be calculated: (1,000 * ($3 – $2)) + (500 * ($3 – $1)) = $2,000.

Section 3 – Expense Recognition

When reporting your expense, at a minimum, you should report the following information:

1. Projected Fair Value – This is the total amount of expense expected to be recognized. This includes everything expensed to date, the amount being expensed in the current period, and the amount to be expensed in future periods.
2. Expense Reported – This is the amount of expense recognized prior to the beginning of the current reporting period.
3. Projected Expense - This is the amount of expense that you expect to recognize in the current period based on the amortization schedule at the beginning of the period or at grant date (if the option was granted during the current period).
4. True-Up Amount – If you are recognizing a “true-up” during the current period, then this is the total credit or debit being reported in the current reporting period.
5. Expense to Report - This is the total amount of expense being recognized as equity compensation expense in the current reporting period. This would be: Projected Expense + True-Up Amount.
6. Total Reported Expense – This is the total amount of expense that has now been recognized through the end of the current reporting period. This would be: Expense Reported + Expense to Report.
7. Remaining Expense (otherwise known as Unrecognized Compensation) – This is the amount left to expense over the remaining service period after the current reporting period. This would be: Projected Fair Value – Total Reported Expense.
8. Weighted Average Period to Recognize Unrecognized Compensation – This disclosure is an estimate of the amount of time it will take to fully expense the remaining amount of unrecognized equity compensation expense. To calculate the remaining period left to expense all option grants, you take the number of months from the current reporting period end date for each option grant * the unrecognized expense for that future period. The sum of this value for all grants is then divided by the total unrecognized expense. This will be the weighted average period left to recognize the unrecognized equity compensation expense. Note that this disclosure should be reported based on a number or years, such as 2.25 years. If you would like to see a sample of how I determine this number in Excel, please email me at jwright@twostep.com.

These are the minimum required disclosures for plain-vanilla stock option grants related to equity compensation reporting for non-public companies. Your audit firm may require additional disclosures. In addition, I did not cover disclosures required for restricted stock or disclosures that are not related to stock options. If there are other items that you have questions about, please let us know.

I hope that this series on valuation, expensing and disclosures under FAS 123R (now ASC Topic 718) has helped you understand the basic steps related to this very complicated task. There are many interconnected pieces to determining the calculations, variables, expensing and reporting. That is why it is often difficult to do all these steps using multiple related spreadsheets.

If you are interested in seeing how a consolidated online equity management system can make it much easier to generate these disclosures, sign up for our free webinar on cap table management and option expensing.