ASC 718

ASC 718 Inputs: Expected Term, Volatility & Risk-Free Rate

FairValueX Team · 9 min read

Expected Term

Expected term is the period over which the option is expected to be outstanding — not the contractual term. For employee stock options with a 10-year contractual term, the expected term is usually 5-7 years because employees typically exercise before expiration.

The SEC Simplified Method

For companies without sufficient historical exercise data, SAB Topic 14 provides the simplified method:

When Can You Use the Simplified Method?

• ✓ The company has insufficient historical exercise data to provide a reasonable basis for estimating expected term
• ✓ The option is a "plain vanilla" stock option — granted at the money, with service-only vesting, and exercisable for a fixed period after termination

When you can't use it: Public companies with 5+ years of exercise history are expected to use their own data. Performance-vested or market-condition awards don't qualify as "plain vanilla."

For Companies With Historical Data

Companies with sufficient exercise history should analyze actual patterns:

• Average time from grant to exercise for exercised options
• Average time from grant to forfeiture/expiration for unexercised options
• Weighted average considering both groups
• Segmentation by employee level (executives vs. non-executives often exercise differently)

Expected Volatility

Expected volatility measures the expected magnitude of stock price fluctuations over the expected term. It is the single most significant input in the Black-Scholes-Merton model.

Public Companies: Historical vs Implied

ASC 718-10-55-36 notes that while historical volatility is a "starting point," companies should also consider factors like mergers, significant changes in leverage, or shifts in business model that might cause future volatility to differ from historical.

Private Companies: Comparable Public Company Approach

Since private companies have no observable stock price, volatility must be estimated from comparable public companies. Key considerations:

• Comparable selection: Same industry, similar size, similar stage of development
• Measurement window: Must match the expected term (if expected term is 6.5 years, use 6.5 years of comparable data)
• Number of comparables: Use a portfolio (5-10 companies) rather than a single company to reduce noise
• Calculation method: Daily closing prices, log-normal returns, annualized using √252 (trading days)

Common audit finding: Using a 5-year measurement window when the expected term is 6.5 years, or using only 2-3 comparable companies

Risk-Free Rate

The risk-free rate should be based on U.S. Treasury zero-coupon bonds with a term matching the expected term of the option.

The risk-free rate is the least controversial input: it's directly observable and mechanical to determine. But auditors still verify that the correct maturity was used and that the rate was pulled as of the correct date.

Dividend Yield

For companies that pay dividends: use the expected continuous dividend yield based on the company's dividend policy. For companies with no dividends (most startups): use zero.

If the company expects to initiate dividends during the expected term, the expected yield should reflect this. For most venture-backed companies, dividend yield is zero and uncontroversial.

Input Sensitivity: What Matters Most