Black Scholes Overview
The Federal Accounting Standards Board (FASB) requires that all companies must expense the value of the share based compensation issued to their employees in accordance to ASC 718 (formerly known as SFAS No. 123).
While ASC 718 does not express a preferred valuation method, the SEC suggests the valuation method should adhere to the following:
- Is applied in a manner consistent with the fair value measurement objective and the other requirements of ASC 718.
- Is based on established principles of financial economic theory and generally applied in that field.
- Reflects all substantive characteristics of the instrument.
Quoted from an Interpretive Response by the SEC:
The option pricing model used should be consistent with generally accepted valuation methodologies, incorporating all factors and assumptions that would be respected by market participants. Such factors include, but are not limited to:
- The exercise price of the option
- The fair market value of the stock
- The expected term of the option
- The expected volatility of the stock
- The expected dividend yield
- The risk-free interest rate
The valuation of a private entity is often derived through the Black-Scholes Model. The Black-Scholes Model is one of the most commonly used option pricing models in the financial industry. The greatest strength of the BSM is its simplicity. The model works by entering fixed inputs (note above) into a formula to compute the value of an option.
In the next few articles, we will be breaking down each of the factors that the Black-Scholes Model is composed of and how Carta computes these numbers.
Note: Carta assumes the dividend yield for all private entities to be 0. As a result, there will be no article explaining the matter.