Background
A frequent question we get from companies is:
Why is the valuation of stock options in Carta’s stock compensation expense reports using a volatility value that is different from the volatility value used in a 409a valuation report?
Simply put, the two reports measure volatility over a different period of time and under a different methodology.
Key Points
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The volatility assumption in the 409a valuation should not be used to value options under ASC718
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A measurement of volatility over a different period of time will result in a different volatility
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The 409a valuation may use a percentile while ASC718 must use a simple average
What is volatility?
The volatility used in a Black Scholes option pricing model is a measurement of how the stock price of a company changes over a specific period of time.
Measurement period
The measurement period used within a 409a valuation is a company’s time to a liquidity event (otherwise referred to as “time to exit”) which constitutes the time until the Company issues an initial public offering (“IPO”), is acquired, or liquidates assets through a dissolution sale.
Under ASC718, the measurement period is the expected term of the stock option, which is the expected time the option is expected to be outstanding regardless of the company's financial health and time to exit. Carta uses a practical expedient to calculate the expected term:
Percentile vs Average
Within a 409a measurement, a higher volatility percentile is usually selected with consideration that the company has relatively limited access to capital, is operating at a cash flow deficit, is substantially smaller, and has a more limited operating history than comparable publicly traded companies.
Although the same logic may be applied for valuing options for stock compensation, ASC 718 explicitly states that a simple average must be used with each company given equal weight.
“A nonpublic entity will need to exercise judgment in selecting a method to estimate expected volatility and might do so by basing its expected volatility on the average volatility of otherwise similar public companies”
-ASC 718-10-55-25
Example
Let’s assume a stock option has a single 4 year vesting period and expires 6 years from the grant date. The expected term would be 5 years.
In the example peer set below, the average volatility for a measurement period of 5 years is 55.41%:
In contrast, the average volatility for a measurement period of 3 years is 60.25%:
As previously mentioned, the 409a may not use a simple average but instead a percentile. The below example shows the selected volatility being used in the 409a valuation to be ~80%, which is roughly the 90th percentile of volatility over a 3 year measurement period.
This would be an example of why an 80% volatility value (blue highlights) was used in a 409a valuation while a 55.41% volatility value (red highlights) was used to value stock options for stock compensation expense under ASC718.
General Impact of Volatility
Higher 409a Volatility = Lower 409a value = Lower Compensation Expense
When determining the value of common stock, a higher volatility assumption would increase the value of the option which would then result in a lower common stock value. This in turn would mean that the options to purchase less valuable stock are less valuable which reduces compensation expense on the income statement and helps the company’s bottom line.
Lower ASC718 Volatility = Lower Compensation Expense
As an input to valuing a stock option, a lower volatility assumption will estimate that the underlying value of the stock will not grow as much which results in a lower fair value of the stock option. This in turn will reduce the amount of stock compensation expense on the income statement and helps the company’s bottom line.