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Breaking Down Black-Scholes: Expected Term

By Calvin Cheng posted 02-07-2023 10:41


You record your stock comp expenses at least once a year, if not monthly, but how did the summary amount to what it did? To answer this question, we have to work backwards. The fair value of an award is key in calculating expenses, but before we can even get to that we must first understand where fair value comes from. 

At Carta, we determine fair value by using an option-pricing model called Black-Scholes. One of the many inputs of this equation is the expected term.  The expected term represents the amount of time the award is expected to remain outstanding until it is exercised or terminated.  Imagine having an option that expires today, and using it to purchase stock worth $1 at an exercise price of $1. Paying for the option to buy something equal to the cost would result in a net loss-something that most people want to avoid.  But what if the option to purchase was outstanding for one year instead of one day?

When more time is attributed to an award, the stock price is given the opportunity to fluctuate. The trajectory then begins to demonstrate an increase in stock price, and ultimately the value of the option, over an extended period of time.

Additionally, being able to delay the exercise longer allows for earning more risk-free interest, effectively reducing the present value of the exercise price.

Generally, the longer an option is outstanding, the option will be more valuable resulting in greater stock compensation expense to the company.