Two Step's Private Company Equity Management Blog

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):

1. Learn to Roll Over - Value the option grants
2. Learn to Crawl - Expense the option grants
3. 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.

1. 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.
2. Exercise Price - This is typically the same as your FMV.
3. 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.

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

1. Go to the Federal Reserve Board site and download the Treasury Constant Maturities.
2. This gives you forward looking rates for 1, 2, 3, 5, 7 and 10 years.
3. 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.

5. Volatility - In order to determine your historical volatility, you need to do the following:

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

6. 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.

I was at a law firm the other day listening to three attorneys debate whether their spreadsheets were a satisfactory tool for doing their transactional clients' capitalization tables. The first attorney (we'll call her Susan) said that her spreadsheets were fine. Her stock plan administration worksheets rolled up automatically into a few other worksheets for a client's capitalization tables and those worksheets could show the data by class, type, date, and fully-diluted.

It all sounded very complicated, but I was impressed. The next attorney (we'll call her Ann) said that her spreadsheets could track the stock and option data, but could not display it by date in the past or in the future. Also, her spreadsheets could not handle option vesting schedules. The third attorney (“Eric”) asked if Ann used the same spreadsheet templates as Susan. Ann said that her spreadsheets were similar to Susan's, but with some variations. Eric admitted that he’s basically a spreadsheet novice.

The reason we were discussing capitalization tables is that they are critical decision-making tools for CFOs, investors, board members, attorneys and clients – and they need to be 100% accurate. Anything less is bound to make someone look very bad. Sometimes the problem is as simple as two people with two different versions of the same stock issuance or option grant data.

As the innocent bystander in this rousing discussion, I commented that it sounded like everyone was doing the record tracking and corresponding capitalization tables slightly differently. Then I suggested they consider an online, consolidated system for ownership administration – for five pretty compelling reasons:

1. Centralize and Share Data: If data needed for capitalization tables is in one place – rather than in multiple copies of spreadsheets – there are fewer discrepancies. Centralized online data can also be shared more easily.
2. Simplify Data Entry: Data can be entered more accurately if all you have to think about is point-and-click. It means less typing and no tedious copying and pasting.
3. Automate Calculations and Reports: A computer-based system will never make a mistake, no matter how difficult the calculation.
4. Increase Standardization and Best Practices: If everyone is doing tasks the same way, you have the ability to set best practice standards and ensure consistency enterprise-wide.
5. Connect Data to Documents and Accounting: In a consolidated system, it is much easier to link related stock plan administration data and documents, such as Board minutes to option grants or grant data to complex FAS 123R reporting.

Susan objected only when I mentioned that a centralized system would reduce the risk of errors. She insisted that her capitalization tables were accurate. And while I had no reason to doubt that, I asked whether her spreadsheets could handle changes in the preferred stock conversion ratios, for instance, or a stock split. Susan replied with an emphatic “yes." She explained that she just copied and pasted the new ratio down the entire column and the next cell generated the updated calculation.

I told Susan that this was precisely where errors happen. In fact, I saw a reference recently to a KPMG report that suggested the vast majority of operating spreadsheets used in financial reporting contain material errors – which is consistent with what we hear from CFOs every day. Even when they have not yet encountered problems, these CFOs say that they are ever-fearful that their resident “spreadsheet guru” might leave (and take their ability to use complex and connected spreadsheets with them).

It's not that spreadsheets are bad or can't handle complex calculations. Of course they can. It's just that the standardization and simplification benefits of an online stock plan administration application are overwhelming. This is particularly true when you consider many different people, using many different spreadsheets, to track many different equity transactions, for many different companies that each have complex capital structures. The risk that an error may creep into the process and flow through the entire system is tremendously high. Another benefit of a web-based system is the opportunity to save money by redirecting routine tasks to a lesser-skilled and lower-cost person.

The next time you're working with complicated spreadsheets for your ownership administration and capitalization tables, consider this: What if you could simplify, standardize, and centralize the work while creating a process that costs less and increases accuracy? When you're ready to stop worrying about hidden errors or copying the right numbers into the right cell, take a look at Two Step's Corporate Focus system to find out what an online, consolidated equity management application could do for you. After all, you have far more important things to worry about these days.