If you’re reading this post, it's likely that you have just started preparing an ASC 718 report. As you begin to document the financials of your company, you will quickly realize that a key element in doing so is providing a realistic price for the options granted by your company. Similar to how you must know the precise dollar amount of your employee’s salary, you must also be able to document the worth of the options you have granted. This post will present a high-level overview of the formula and inputs used to determine the fair value of your option grants when preparing the ASC 718 report. 

What Is Fair Value and How Does It Compare to Fair Market Value?

Although often used interchangeably, to an accountant, fair value and fair market value are two completely different ball games. Much like baseball, fair market value is the more popular of the two terms. Essentially, fair market value is the expected price of your company’s grants if they were to be sold on an open market. For this reason, the IRS requires that fair market value be established via a “reasonable valuation method” and then generally used as the lowest possible strike price. Typically, fair market value is determined by a 409A Valuation Report or a Board analysis. That being said, when it comes to ASC 718 reporting, fair market value is merely one of the inputs used to calculate fair value. Fair value, while lesser known, does require skillful math and, like croquet, should not be overlooked. The subtle nuance between fair market value and fair value is that fair value takes into consideration more than just the predicted value of shares on an open market—it also factors in certain adjustments in fairness to both the company and its prospective investors. For instance, fair value considers both fair market value and additional factors, such as the interest rate and the grant’s expected volatility. For this reason, it is possible and likely for your company’s fair market value to be different from your company’s fair value (generally speaking, fair market value is less flexible and priced lower than fair value). In order to be well versed at ASC 718 reporting—and know what to look for in your report as well—knowing the difference between fair value and fair market value is as important as knowing whether or not you are going to play baseball or croquet!

Why Is an Option’s Value Unknown?

Now that some terminology has been established, it is imperative to ask the question: Why must we calculate fair value? Shouldn’t people know, more or less, what their company’s options are worth? The simple answer is, no. In fact, the true value of an option is actually quite complex to derive since most startups are private companies and their shares are not traded in a public market. Even for public companies or private companies that have existed for quite some time, the option’s fair value is different from the stock price (and therefore unknown). This is because an option is worth more than just the value of the share in a specific moment in time. An option allows you to “work” with your money, while watching market trends. 

Since an option’s true value is unknown, economists have devised models to determine the financial worth of options at private companies. This is known as determining the “fair value” of an option grant. In order to determine the value of a grant, two different steps need to be taken. First, you must calculate the fair value of the option. Then, you must use the grant’s economic lifecycle to allocate the expenses associated with that option grant over a given period. This blog post will cover the first of the two steps.

What Are My Options When It Comes To Calculating Fair Value?

The ASC 718 topic does not specify a model that must be followed when performing the fair value calculation, and several approaches exist when it comes time to calculate fair value. The three most common calculations are the Black-Scholes formula, the Lattice Model, the Monte Carlo Simulation. Without going into too much depth about the mathematical nuances between the three different models used to arrive at fair value, it suffices to say that the Black-Scholes formula is by far the most popular. This is largely because the Black-Scholes method produces a definite numerical answer for fair value while relying solely on six basic inputs specific to the company and grant. Since the calculation is so widespread, it is also understood and accepted by both investors and auditors.The Lattice Model, on the other hand, uses the same inputs at the Black Scholes calculation but takes the Black Scholes math one step further by constructing two binomial probability trees. Although this formula is known to model US options quite accurately, it is extremely complex and time consuming when it comes to implementation, and often will require additional information which may not be available to a company in its early lifecycle stages. If the mention of binomials had your stomach twisting and envisioning involved mathematics on chalkboards, the Monte Carlo Simulation method is no laughing matter. Based on Brownian motion with a drift, this calculation relies on random input parameters to simulate different fair value outcomes (and is even more complex when it comes to implementation than the Lattice Model approach). For these reasons, the majority of users opt to calculate fair value by using the Black-Scholes formula. This is the methodology adopted by Fidelity Private Shares for a typical early-stage startup, not only because it is the most practiced method of calculating fair value, but also because it is friendly to startups since it places a strong emphasis on volatility (and peer companies tend to be less volatile than startups). 

What Goes Into A Fair Value Calculation?

Following the Black-Scholes methodology described above, you will need six inputs for each option grant to calculate fair value:

1. Option strike price (also known as the exercise price)
2. Fair market value of the grant
3. Expected dividend yield (since we are calculating fair value for a startup, the dividend rate is almost always 0.00% unless a company has paid dividends)
4. Expected term of the grant (from start to expiration)
5. Volatility of the option price
6. Interest rate (as a reference point for a risk-free investment)

While the first three inputs are relatively easy to identify, the latter three do require a fair bit of math before you can properly use them in the formula. For instance, the expected term of a grant is not simply the period between the start date and the expiration date of the grant. Instead, it must account for terminations and early exercises. For this reason, there are standard practices you must follow to get this term correct. In the same way that the expected grant term’s calculation has been standardized, to determine the volatility of an option price you are required to look beyond your company financials to evaluate risk. An option’s volatility is measured by selecting peer companies in the public market, and averaging the statistical variance of stock prices. The reason why this value is important is because the peer companies’ history will serve as a comparison for your company’s predicted stock fluctuations. The final input that you must also identify before using the Black-Scholes formula is that of the interest rate during the period of the option grant. The purpose of this input is to provide an example of a risk-free investment to be compared with the option grant. Therefore, a weighted average of the interest rate for the time period of the grant can be calculated from the information published by the US Treasury. (Although risk-free investments are only possible in theory, the US government has a AAA credit rating, since it is expected to always pay its debt, so for this reason government bond yields are a proxy for providing a risk-free interest rate.) Once you have all six inputs, it’s time for the old plug-and-chug into the Black-Scholes formula.

As you can see, there are a lot of steps involved in deriving the valuation for a private entity’s equity. And you’re not done quite yet—now that you have calculated this information it is time to report it correctly. That being said, Fidelity Private Shares can simplify the ASC 718 process by having computers do the math for you (phew!) and by making sure that your company’s ducks are always in a row—so that you’re ready for an audit from day one.