What is a Forfeiture Rate?
The forfeiture rate is the percentage of options that you expect to cancel in a year based on historical data.
So for every single year in which options are granted, you have to estimate the forfeitures for the following four years.
Most companies find that the majority of forfeiture occurs in the first year and then tapers off over time.
When to Use It?
Your option expense report, like any other expense in your company, is fundamentally reducing your tax liability.
For most companies, your option expense is not going to be substantial, but for some companies, it could be a significant amount.
The only reason you would want to use a forfeiture rate is if you grant a massive amount of options in a particular year and want to smooth out your reported expenses from year to year to show a consistent picture.
How to Come Up with an Accurate Forfeiture Rate
You must base your forfeiture rate on historical data.
The objective here is to figure out the likelihood that someone will leave options they were granted before they all vest. We will want to figure out the likelihood of this happening for each of the 4 years following a grant.
This is where software like Shareworks Startup Edition can really be useful.
The solution can analyze what your actual forfeiture rate has been if you have enough historical data or if you are a startup it can start you off with the average forfeiture rate across all startups.
NOTE: When calculating your stock option expense, you will only apply a forfeiture rate to shares that have not vested.
So if all your grants have a 1-year cliff and vest monthly thereafter, you may be thinking you only need to figure out the likelihood of forfeiture during an employee’s first year.
While that’s technically correct, it is still important to calculate the rate of forfeiture for every year so that the model can be applied if or when you introduce a non-standard vesting schedule.
An example of calculating forfeiture rate based on historical data:
Let’s say you granted options in 2002 and in the first year of vesting (2003) saw 30% of those forfeit.
Then we find that in 2004 (year 2) another 20% of the options granted in 2002 were forfeited.
The same thing is done for years 3 and 4.
You’ll want to repeat this for every single year and then do a weighted average to come up with the likelihood that shares will be forfeit 1, 2, 3, and 4 years after being granted.
So you build out a history of percentages that were canceled in each year and then you just do a weighted average based on the number of shares granted across as many grant years as you can provide accurate data for.
What you’re likely to find is that new employees receiving stock options will forfeit their shares perhaps 30% of the time in year one and then it tapers off to something more like 15% in year 2 and so on.
In other words, if the employee is willing to stay around for one year, they’re very likely to be willing to stay for the following 3 years.
On the flip side if there’s a problem with the employee like a bad fit with the company they’ll typically leave within the first year. So that’s why we see a relatively large forfeiture rate in the first year.
Why Most Companies Should Not Use a Forfeiture Rate
The first problem for private companies is that most of them are startups without a long history of grants and forfeitures.
Not only is your sample size likely to be quite small if you are a startup, but you probably also issued large option grants during your first couple of years.
As a result, more shares are likely to be forfeited during the first couple of years, creating huge swings and outliers.
If you give a founder 40% of the company and he leaves the next year, all of those options go away.
On the flip side, that founder might stay in which case you’ll have a massive outlier pulling the average forfeiture rate towards 0%.
We’re doing weighted averages so that could be a massive outlier that is not indicative of what your company’s forfeiture rates will be in the future.
It skews your averages dramatically when your history of forfeitures is relatively small.
So in the first several years, many startups can have a 0%, 80% or even 90% forfeiture rate and then move closer to a 30-35% forfeiture rate as they mature.
Unless you assume a 0% forfeiture rate (more on that in the next section below) your auditors are going to question the forfeiture rate you pick.
If you have a relatively small amount of historical data, it’s going to be difficult for you to defend the forfeiture rate you come up with.
GAAP Update – 0 Percent Forfeiture Rates
In 2016 an accounting pronouncement was made (ASU 2016-09) allowing you to account for forfeitures as they occur, eliminating the need to estimate forfeiture rates.
So this essentially allows private companies to assume a 0% forfeiture rate.
This is what we almost always recommend that you do. It’s one less estimate to justify to your auditors.
Our ASC 718 stock expense software allows you to use whatever forfeiture rate you choose.
But for all the reasons mentioned in the section above, it is typically best to just go with a 0% forfeiture rate.
Stock Option Accounting with a Custom Forfeiture Rate
No matter how accurate your forfeiture rate is, it’s still going to be slightly off from year to year.
So you will always have to make corrections the following year.
Shareworks Startup Edition will make the corrections automatically for you, but if you’re not using it, they can really be a pain to do.
You never reverse expenses for shares that actually vest.
So if you have shares that are vested and an employee forfeits those shares by leaving the company and never exercises them, the expense remains.
The purpose of the shares was to incentivize the employee to stay at the company until they vest and that’s exactly what they did. It’s not your fault that they didn’t exercise them.
As a result, you only ever apply the forfeiture rate to shares that are within a cliff period.
Most spreadsheet models will only account for one-year cliffs.
So if you ever use a cliff of anything less than one year, most models don’t account for that and you’re missing out on applying a forfeiture rate to a bunch of options that should be accounted for.
Startup edition will apply a forfeiture rate to any cliff that is larger than 1 month.
Forfeiture Rate Calculation Example:
So let’s say that you hired an employee in July you have $400 worth of expense vesting over 4 years with a 1-year cliff and then monthly after that.
You would have $50 worth of options in year one that would need to have a forfeiture rate applied to it since it is unvested.
Let’s assume that your forfeiture rate is 20% to make the math easy.
After applying a forfeiture rate the $50 worth of expense now becomes $40 because we think that an average of 20% of options will cancel.
Let’s say it’s been a year now. It’s July, we’re in the second year, the cliff finished, the employee is still with us and everything up to that point is now vested.
How much would our expense be if we were to calculate it now (July of the second year)?
Well, we had six months of unvested options to expense in year 1, and we now have another six months of options (vested this time) to expense today.
Last year we only expensed $40 of the $50 worth of options to account for forfeiture.
Since last year’s options have now vested we must undo the forfeiture which is $10.
We also have another $50 of options to account for this year. Since these are vested options we don’t apply a forfeiture rate.
Our total expenses are:
- $40 for the first year
- $60 ($10 + 50$) for the second year (the first half of the year)
One more example:
What would happen in the above example if the employee had instead quit during their second year before their options vest.
The $40 you expensed in the first year was not true. So for the second year, you would have a -$40 expense for that employee.
Startup edition will do these type of adjustments automatically for you.
Stock Option Accounting with a 0% Forfeiture Rate
If your compensation expense is relatively small compared with your other expenses then the act of going through the manual process of applying forfeiture rates and correcting for them is just not worth the value.
The value at the end of the day is smooth financial figures and since the compensation expense is relatively small your financial figures will be smooth either way.
Let’s use the scenario we used above but instead see how it plays out using a 0% forfeiture rate.
Let’s say that you hired an employee in July. You have $400 worth of expense vesting over four years with a 1-year cliff and then monthly after that.
At the end of year one, the employee would be ⅛ of the way through their vesting schedule so we would expense $50 of the $400 worth of options.
If the employee stays until their options vest the following year then great. No adjustments are necessary.
But what do we do if that employee leaves in the second year before their options vest?
In this case, you just reverse the expense from year one: -$50.
So our total expenses are:
- $50 for the first year
- -$50 for the second year
The Advantages of Using Shareworks Startup Edition
Startup edition is great for dealing with forfeitures because it gives you two significant advantages:
- If you don’t have a reliable history, it will tell you what the average is across other startup companies.
- If you do (or once you do) have a reliable history it calculates the forfeiture rate for you automatically.
If you decide to use a forfeiture rate, the solution will apply it automatically to any included shares in your expense report.
Perhaps more importantly, whether you use a 0% forfeiture or not, startup edition automatically makes the necessary corrections to true up your expense reports from year to year.
You don’t have to do anything other than make sure that your cap table is accurate.
- What is Stock Option Expensing and Do I Need to Do it?
- How to Expense Stock Options Under ASC 718
- How to Expense Stock Options Using Software – Step-by-Step Guide
- How to Account for Expired Stock Options