RADFORD REVIEW
Forfeiture Rate Analysis
Companies that issue equity awards to their employees are required to apply a prevesting forfeiture rate to the accrual of stock-based compensation expense under ASC
Topic 718. Many companies have an established process for developing and updating
their forfeiture rate assumptions annually or occasionally quarterly. Others have applied a
less rigorous approach. In either case, it is important to note that this is not always a
straight-forward exercise even with an established process. Professional judgment and
advice of independent valuation experts are frequently needed.
Not all forfeiture rates are created the same and the development of them is not a trivial
matter. There is more than one definition of a forfeiture rate and a few acceptable
approaches to applying the rate. This Radford Review will highlight a number of
approaches in developing a forfeiture rate. It also will review and address additional
considerations, pitfalls, and recommended adjustments for these common issues.
Regulatory Guidance
The bulk of all regulatory guidance for fair value methodology and assumption
development of employee equity awards is contained in the following three references:
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Financial Accounting Standards Board (FASB), ASC Topic 718
PCAOB, “Auditing the Fair Value of Share Options Granted to Employees”
Securities & Exchange Commission (SEC), Staff Accounting Bulletin #107
It is interesting to note that both the PCAOB and SEC were largely silent on the issue of
developing a forfeiture rate. On the surface it is understandable since forfeiture rates are
not an assumption used in determining the fair value of the instrument. Instead, as ASC
718-10-35-3 states, it is an assumption used in the accrual of compensation expense:
“An entity shall base initial accruals of compensation cost on the estimated number of
instruments for which the requisite service is expected to be rendered. That estimate
shall be revised if subsequent information indicates that the actual number of
instruments is likely to differ from previous estimates.”
Nevertheless, the development of a forfeiture rate is just as critical to understanding how
estimated volatility and expected life are determined for option fair values.
Radford, an
Aon Hewitt Company
Radford Review: Forfeiture Rate Analysis
08/11
Types of Forfeiture Rates
There are two common types of forfeiture rates: aggregate and annualized. An aggregate
forfeiture rate represents the percent of all awards granted that are expected to forfeit. An
annualized forfeiture rate is the aggregate rate adjusted for the vesting schedule and
measures the percent of grants forfeited each year. The annualized rate is more common
in practice and more flexible since it can be applied to all vesting schedules.
Developing Forfeiture Rate
There are various sources from which a company can develop a forfeiture rate. We will
discuss the usage of historical equity data, headcount turnover, and other data sources.
Historical Equity Data
The following outlines the steps for developing historical forfeiture rates:
(1) Analyze grants and their associated vesting schedule
The average vesting period is calculated according to the vesting schedule for each
grant and weighted by the number of awards granted. For example, a three-year
annual vesting schedule with 33.3% of the awards vesting at the end of each year
results in an average vesting time of two years, as shown below:
Time (Years)
1
2
3
% Vesting
33%
33%
33%
Weighted Average Vest Time
Total Vested
0.33
0.67
1.00
2.00
(2) Complete forfeitable periods for cancellations
The average forfeitable period is calculated for each cancellation and represents the
amount of time an award is exposed to forfeiture. This is based on either the period
between the measurement date and the grant date or the average vesting time
calculated in (1), whichever is shorter. Note this is only done for pre-vesting forfeitures
as forfeiture rate only affects the non-vested shares.
(3) Calculate aggregate forfeiture rate
The aggregate forfeiture rate is simply the ratio of pre-vesting forfeitures (the awards
forfeited less the post-vesting cancellations) over the awards granted.
(4) Annualize forfeiture rate
Aggregate forfeiture rate is annualized by applying the following formula:
The annualized rate takes each vesting schedule into account and captures the time
that the award is exposed to the risk of forfeiture.
Radford Review: Forfeiture Rate Analysis
08/11
Sample Data
The table below illustrates the historical forfeiture by year of grant:
Year of Grant
Granted
Awards
Forfeited
Awards
2004
2005
2006
2007
2008
2009
2010
1,286,000
1,587,000
2,594,300
2,898,800
2,242,800
2,325,220
1,717,680
321,717
412,092
655,422
772,188
377,321
370,661
260,200
Average
14,651,800
3,169,601
Average
Forfeitable
Period
2.00
2.00
2.00
2.00
2.00
1.75
0.74
Average
Vesting
Period
2.00
2.00
2.00
2.00
2.00
2.00
2.00
1.81
2.00
Aggregate
Annualized
Forfeiture % Forfeiture %
25.02%
25.97%
25.26%
26.64%
16.82%
15.94%
15.15%
13.41%
13.96%
13.55%
14.35%
8.80%
9.43%
19.89%
21.63%
12.58%
The table below illustrates historical forfeiture by job class:
Job Class
Granted
Awards
Officer
Non-Officer
4,824,493
9,827,307
Average
14,651,800
776,867
2,392,734
Average
Forfeitable
Period
1.83
1.80
Average
Vesting
Period
2.00
2.00
3,169,601
1.81
2.00
Forfeited
Awards
Aggregate
Forfeiture %
Annualized
Forfeiture %
16.10%
24.35%
9.13%
14.34%
21.63%
12.58%
A few considerations are addressed here to ensure proper adjustments are made when
developing the forfeiture rate:
Partial Vesting Cycle – In the Sample Data shown above, the awards issued in 2009 and
2010 are only partially through their full vesting schedule. This is reflected by the Average
Forfeitable Period being less than the Average Vesting Period. The partial vesting cycle
is properly accounted for since the Aggregate Forfeiture % is annualized using the
Average Forfeitable Period.
Stratification – Often times, stratification of forfeiture rates based on different criteria is
necessary. As shown on the second chart above, the turnover rate is 14.34% for NonOfficers while it is 9.13% for Officers. The difference is significant and is a good indication
that stratification by Job Class should be considered. In addition, options and restricted
stock/RSUs could be analyzed separately as they are frequently granted to different
groups of employees.
Data Exclusions or Other Adjustments – There may be an unusual number of awards
being forfeited when a company implements a reduction in force (RIF), restructures
management teams, or undergoes a merger and acquisition. Professional judgment
should be used in determining whether certain data should be excluded or adjusted.
Future vs. Historical – As the company considers certain adjustments or stratification, a
key factor in making these decisions is whether or not the historical data represents the
future of the company. If the answer is no, data should be carefully examined and
adjusted appropriately.
Radford Review: Forfeiture Rate Analysis
08/11
3
Headcount Turnover
Another method of estimating forfeiture is to measure turnover by headcount. The
headcount turnover is simply the ratio of the number of employees terminated divided by
the total number of employees. This is done for each year and the weighted average is
calculated based on the number of employees, as illustrated below:
Year
2006
2007
2008
2009
2010
Number of
Employees
6,170
6,200
6,150
5,980
5,800
Turnover
Headcount
640
710
650
500
510
Weighted Average
Turnover
Rate
10.37%
11.45%
10.57%
8.36%
8.79%
9.93%
Although the approach appears straightforward, there are a few factors to consider. The
population that is included in the headcount should be consistent with the employees
who receive awards. Also, notice that this method places equal weighting on all
employees. In reality, executives who receive large grants usually have lower probability
of turnover. Skewed results can be created when appropriate weighting is not applied.
Other Data Sources
A few sources may be considered if companies do not have sufficient historical
experience.
Radford Trends Report – Supplemental US Salary Increases and Turnover by Region
and Industry can be used for forfeiture rate estimation. The reports are released quarterly
and group the rates by region, industry, and company size.
Society of Actuaries data and behavior study is another alternative for forfeiture rate
estimation. The weighted average expected forfeiture is based on the age of the
employees at time of grant by applying standard actuarial probabilities of retirement,
termination, death and disability. A simplified example of these rates are shown in the
following table:
Probability of
Forfeiture
Year 0-1
6.2%
Year 1-2
6.9%
Year 2-3
6.6%
Weighted
Average
6.6%
Software Considerations
Most equity administration software platforms have standard reports that provide the
historical forfeiture rates. However, it is critical to understand the type of forfeiture rate
being developed and more importantly, the data being used. The standard reports often
do not adjust for partial vesting periods of recently issued awards and are limited in their
ability to exclude or stratify the data. However, that does not mean the reports should be
ignored. It simply highlights the importance of reviewing the information and applying
professional judgment when appropriate.
Radford Review: Forfeiture Rate Analysis
08/11
Migrating From Spreadsheet to Software
It is necessary to reconcile the differences in the forfeiture rate calculation between the
spreadsheet and software when migrating from one to the other. Often times, the
analysis reveals differences due various approaches. It is important to be familiar with the
capabilities of the software and understand whether the input required an aggregate or
annualized rate and whether the software is capable of both static and dynamic rates.
Summary
Several considerations regarding the determination of forfeiture rates have been
addressed in this Radford Review. An essential part of developing a reliable forfeiture
rate is to use professional judgments in analyzing the historical data to ensure it is
representative of what is expected in the future. Regardless of the forfeiture applied to
the compensation cost, the company will be required to “true-up” or “true-down” the
forfeiture assumption to actual experience.
Radford Review: Forfeiture Rate Analysis
08/11
Contact Us
For more information,
please contact:
Jon W. Burg, FSA
+1 (415) 315.7137
jburg@radford.com
Harmony Chi, ASA
+1 (415) 315.7133
hchi@radford.com
Locations
Austin, Bangalore,
Beijing, Boston,
Chicago, Hong Kong,
London, New York,
Philadelphia, San
Francisco, San Jose,
Shanghai and
Singapore
Jon W. Burg, FSA
Vice President
Jon Burg is vice president and West Coast Practice Leader of Radford Valuation
Services, the equity valuation group of Radford, an Aon Hewitt Company. He has
thirteen years of benefits and compensation consulting experience, including all
forms of equity compensation. Jon collaborates directly with management and
compensation committees to design sound equity compensation plans, practices and
procedures. He also works with companies on the valuation and financial
management of their retirement and equity compensation programs, leveraging an
extensive actuarial background to provide rigorous analysis of historical plan
experience. He earned a bachelor of science in mathematics and economics from the
University of Washington. He is a Fellow of the Society of Actuaries and an Enrolled
Actuary. Jon frequently speaks on a variety of equity compensation topics at industry
events, including national and local NASPP conferences.
Harmony Chi, ASA
Analyst
Harmony Chi is an analyst with Radford Valuation Services, the equity valuation
group of Radford. She has consulted on a variety of employee equity compensation
issues, including the valuation and financial reporting of employee stock options and
ESPPs under Topic 718, design and valuation of underwater stock option exchanges,
and complex valuations of performance-based awards. Harmony graduated from
University of California at Berkeley with a bachelor of science degree in mathematics.
She is an Associate of the Society of Actuaries. Harmony is based in San Francisco,
California.
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Visit www.radford.com, or for more information, contact info.rad@radford.com.
Radford Review: Forfeiture Rate Analysis
08/11