In a stock option expense report, on the “Expense Breakdown” tab, you will see two columns regarding cliff shares, “Begin Cliff Shares” and “End Cliff Shares.” (see below)
So what are “Cliff Shares” and why are they being expensed? In short, cliff shares are shares that have not vested but should be expensed during the period. These are shares that are “earned” in a given period but are not vested till a later date. Perhaps they can be best explained through an example.
Cliff Shares: An Example
Let’s say that Eliza was granted 1,200 shares on 7/16/2015 and that they fully vested one year later on 7/16/2016. Running an expense report for 2015 would show that as of 12/31/2015 Eliza has 0 vested shares but 550 cliff shares.
Eliza is working for 5 and 1/2 months in 2015 that are contributing to the 1,200 options she will earn/vest in 2016. Therefore 5 and 1/2 of the 12 months of the grant should be expensed in 2015. These 550 shares that she earned but are unvested, are the “cliff shares.”
Most people are familiar with vesting plans where there is a large, upfront one-year cliff before any shares vest. But often they do not realize that monthly vesting creates cliff shares too.
Let’s go back to Eliza’s example, but change just one detail – let’s say that her shares vest monthly instead of after one year. So 100 shares will vest on 8/16/2015, 100 more will vest on 9/16/2015, and so on.
If we then run a stock option expense report for 2015, we will see that as of 12/31/2015 Eliza has 500 vested shares and 50 cliff shares. The 50 cliff shares are the shares she has worked for from 12/16/2015 to 12/31/2015 but won’t vest until 1/16/2016 (on 1/16/2016, she will also receive 50 shares for the first half of January, thus vesting a total of 100 shares on 1/16/2016).
Cliff Shares and Forfeiture Rates
With cliff shares, there is a possibility of those shares never vesting due to termination of employment. At the time an employee leaves, any expense accumulated in past periods for cliff shares is backed out in the current period.
In the end, the total expense for an option grant will be for just those shares that vested.
Please note that you would never back out any expense for options that have vested – even if an employee does not exercise their vested options and lets them expire.
FASB guidelines used to require that companies estimate the probability that cliff shares would never vest and then apply a “forfeiture rate” to those cliff shares. For 2016, additional guidelines were published, and the use of forfeiture rates is now optional.
On the “Expense Breakdown” tab of one of Capshare’s option expense reports, you will see a column for forfeiture rates. These forfeiture rates are used only for the cliff shares.
The idea behind using a forfeiture rate is to create a more “smooth” expensing schedule, that is devoid of large decreases in expense in any given month due to terminations. The idea is that on average, in any given month, backing out one terminated employee’s expense will be balanced out by having to catch up on some expense for shares that you had previously applied a forfeiture rate to, but have now fully vested.
In reality, for many companies, forfeiture rates did not do much in the way “smoothing” out the expense, and in turn, only increased headaches. That is largely why the use of forfeiture rates is now optional.
Cliff Shares and Forfeiture Rates: An Example
Let’s go back to the example of Eliza’s grant that vests monthly. If you recall, as of 12/31/2015, she has 500 vested shares and 50 cliff shares.
Now let’s say that the fair value of her options is $0.25 a share and we are applying a 5% forfeiture rate.
Eliza’s total expense for 2015 will be $136.875 – see the example below:
Here is how we get to those final numbers:
$125 = 500 shares * $0.25
$11.875 = 50 shares * $.25 * (1 – 0.05)
The $0.625 in expense not recognized on the 50 cliff shares due to the forfeiture rate will be expensed at the time those shares vest. If the 50 shares never vest, the $11.875 of expense will be backed out in the next reporting period.