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Calculating Expected Term

By Shevaun Cash posted 02-07-2023 10:37

  

When it comes to calculations, there are many variables that can affect the expected term or the expected life of the option grant, including but not limited to:

  1. Historical exercise patterns
  2. Employee demographics
  3. Termination rates
  4. Expected volatility of the underlying stock
  5. Price of the underlying stock

Private entities with limited history may not have enough data to properly calculate the expected term of an option. The SEC responded to this with a "practical expedient" or proposed solution for option grants deemed to be "plain-vanilla," known widely as the Simplified Method or mid-point method. This is described in the Staff Accounting Bulletin 107 (SAB 107) found here.


Below we'll break down the expected term with a couple of examples.


To begin with, the general formula we'll be using is as follows:

 

Example 1:


Let's try to calculate the expected term for an option that fully vests over 2 years with a 25% 1-year cliff:


The expected term is estimated to be 5.6855 years.

One thing to note is that this award was approved by the board and has a grant date equal to the vesting start date (often the date of hire).  However, this is not always the case, as board meetings tend to happen quarterly.


Example 2:


Let's determine the expected term if the same award was granted on 3/1/2022, ~3 months after the employee was hired on 1/1/2022.



Although companies may approve a multitude of identical awards on the same day, not all employees were hired on the same day. Thus, not all of these awards would have the same vesting start date.  A different vesting start date would result in a different vesting schedule, a different vesting term, and ultimately a different expected term.


As mentioned in our last blog post, the expected term impacts the value of a stock option. It determines how long we would measure the volatility of peer companies to estimate how the common stock valuation may fluctuate.  It is also used to estimate the amount of risk-free interest that can be earned, which could potentially lower the present value of the exercise price.


Have questions on this subject? Feel free to post below, or reach out to our team at 718@carta.com !

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