Investing in the stock market can be a rewarding experience, but it also comes with its fair share of risks. One of the risks that investors may face is the possibility of forfeited shares. Forfeited shares are equity share investments cancelled by the issuing company. This blog delves deeper into what is forfeiture of shares in accounting.
What are Forfeited Shares?
The forfeited shares definition refers to company shares that have been surrendered or given up by a shareholder due to non-payment of the required amount. When a shareholder fails to make the necessary payments for the subscribed shares, the company has the right to forfeit or cancel them. The company can sell or reissue them to a new shareholder.
Forfeited shares are often seen as a last resort for companies to enforce the payment of the required amount from defaulting shareholders. These shares help companies maintain their financial stability.
How Forfeited Shares Work?
Now that you know the forfeited shares meaning, let’s understand how it works.
Suppose Lalita decides to purchase 5,000 shares, but the company requires an initial upfront payment of 20%, followed by four annual instalments of 20% each, according to a schedule set by the company. If Lalita fails to make one of these instalment payments, the company may decide to take away all her purchased shares. In this case, Lalita would lose the money she had already paid for the shares.
Employee Share Forfeiture
Employee share forfeiture is one of the types of forfeiture of shares when an employee loses the rights to their stock in a company because they fail to meet specific requirements, typically outlined in the company's share plan or agreement.
Example of Forfeited Shares
Forfeiture of shares examples are as follows.
Let's say a company grants 1,000 shares to an employee as part of their compensation package, with a condition that requires the employee to work for the company for three years to fully vest in the shares. The vest is in equal instalments over three years, each ending after a year of employment.
If the employee leaves the company before the end of this period, they may forfeit some or all of their shares. For example, if the employee leaves the company after two years, they may only have vested in 2/3 of their shares, and the remaining 1/3 shares can be forfeited.
Alternatively, if the employee is terminated (e.g. for violating company policy), they may forfeit all of their shares, regardless of their employment years.
In either case, the forfeited shares would be returned to the treasury stock, which the company could choose to reissue or retire permanently.
Reissue of Forfeited Shares
When forfeited shares are returned to a company's treasury stock, they may choose to execute a reissue of forfeited shares. This means the company will sell the shares to new shareholders through a new stock offering or private placement.
The reissue of forfeited shares can have several benefits for the company. It can increase the company's cash reserves, which can be used for business operations or to fund new projects. Reissuing shares can also help the company raise capital without incurring debt or diluting the ownership of existing shareholders.
There are some downsides to reissuing forfeited shares. For example, if the shares were originally forfeited due to a lack of demand for the company's stock, reissuing could dilute the value of existing shares. Additionally, if the company reissues shares at a lower price than the original offering price, it could result in a loss for the company and its shareholders.
Effects of Share Forfeiture
Share forfeiture can have several effects on the employee and the company.
1. Loss of ownership: The employee loses share ownership when shares are forfeited. This means they will no longer have the right to vote on company matters or receive dividends.
2. Loss of potential gains: If the forfeited shares were expected to increase in value over time, the employee might lose out on potential gains. This could be a significant loss if the shares were granted as part of their compensation package.
3. Impact on financial ratios: Such shares can impact the company's financial ratios. For example, if the company has a high number of forfeited shares, it may have a lower earnings per share (EPS) or return on equity (ROE), which could impact investor confidence.
4. Impact on treasury stock: Forfeited shares can increase the number of outstanding shares and dilute the value of existing shares. However, if the company chooses to retire the shares instead of reissuing them, it can reduce the number of outstanding shares and increase the value of existing shares.
5. Legal and tax implications: Share forfeiture can have legal and tax implications for both the employee and the company.
Benefits of Forfeited Shares
Forfeited shares can provide benefits to a company in many ways.
1. When the money paid for forfeited shares is returned to the company, it can be used for various purposes, such as funding future development projects or paying off liabilities and improving the company’s financial position.
2. If the company decides to reissue the forfeited shares, it can sell them at a higher price than their face value. The additional amount received, known as the premium, can be added to the company's reserves and surplus. This can increase its ability to invest in growth opportunities.
3. Overall, forfeited shares can provide a source of funds for a company and increase its financial flexibility and strength.
Factors to consider before you invest
When shares are forfeited, the shareholder loses ownership of them, and they become the property of the issuing company. If an employee leaves before the mandatory vesting period in an Employee Stock Option Plan (ESOP), their options are forfeited. Investors lose the subscription money they have already paid, and there are no capital gains in such cases.
The company can reissue forfeited shares to another shareholder at a different price, usually at a discount, because the company would have relinquished a portion of the initial payment on the shares. This process applies to listed and unlisted companies.