Forfeiture of Shares: Meaning, Example and Benefits

Investing in the stock market can be exciting and profitable, but it also involves some risks. One risk is the possibility of losing shares. Forfeited shares are shares that a company cancels. This blog explains the meaning of the forfeiture of shares.

What is forfeiture of shares?

Forfeited shares are shares that a shareholder has to give up because he/she failed to pay the required amount. If a shareholder does not pay for the shares they have agreed to buy, the company can cancel those shares. The company can then sell or give those shares to someone else. Forfeiting shares is a way for companies to ensure they get the money they need and stay financially stable.

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How Forfeited Shares Work?

Since you know the forfeit meaning and definition of forfeited shares, let us understand how the concept works. 

An investor named John agrees to buy 5,000 shares from a company. He needs to make an initial payment of 25% of the total cost and then pay the remaining 75% in three annual installments of 25% each. If John`misses any of these payments, the company can take back all 5,000 shares, and John will lose the money he already paid.

Employee Share Forfeiture

Some companies enable employees to buy company shares at a discount using part of their salary. However, these plans often have rules. For example, the shares might not be able to be sold or transferred for a certain time after buying them.

If an employee leaves the company before a specific waiting period is over, they might have to give up the shares they bought. But if the employee stays with the company for the required amount of time, they fully own the shares and can sell them whenever they want.

Example of Forfeited Shares

Imagine a company giving an employee 1,000 shares as part of their pay. As per the company policy, the employee who is bound needs to work there for 3 years to fully own these shares. They get 1/3 of the shares each year.

If the employee leaves before the 3 years are up, they might lose some or all of the shares. For example, if they leave after 2 years, they might keep only 2/3 of the shares and lose the other 1/3.

If the employee is terminated for a genuine reason, like breaking company rules, he/she might lose all their shares, no matter how long they have worked there.

Any shares that are forfeited go back to the company. The company can then decide to either reissue or permanently retire these shares.

Reissue of Forfeited Shares

When a company gets back shares that were forfeited, it can choose to sell these shares again. This is called the reissuing of forfeited shares. The company might do this through a new stock offering or by selling them privately.

Reissuing forfeited shares can be helpful for the company. It can bring in extra cash, which the company can use for its operations or to fund new projects. It is a way to raise money without taking on debt or reducing the value of the shares owned by current shareholders.

However, there are some downsides as well. If the company reissues the shares because there was not much demand for them before, it might lower the value of existing shares. Also, if the shares are sold for less than the original price, the company and its shareholders could lose money.

Effects of Share Forfeiture

Forfeiting shares can affect both the employee and the company in several ways:

Loss of Ownership: The employee loses their shares, meaning they no longer have voting rights or receive dividends from the company.

Impact on Financial Ratios: Forfeited shares can affect the company’s financial numbers, like earnings per share (EPS) or return on equity (ROE). A high number of forfeited shares might lower these ratios and affect how investors view the company.

Loss of Potential Gains: If the shares were expected to grow in value, the employee misses out on these potential gains, which can be a big loss if the shares were part of their pay package.

Impact on Treasury Stock: Forfeited shares can either increase the total number of shares in circulation, which can lower the value of existing shares or if the company decides to cancel them, it can reduce the number of shares and boost the value of the remaining shares.

Legal and Tax Implications: There can be legal and tax consequences for both the employee and the company when shares are forfeited. 

Benefits of Forfeited Shares

Forfeited shares can help a company in several ways:

Extra Cash: The money from forfeited shares goes back to the company. This cash can be used for things like new projects, paying off debt, or improving the company’s finances.

Selling for More: If the company reissues the forfeited shares, it can sell them for more than their original value. The extra money, called a premium, adds to the company’s reserves and can be used for business expansion opportunities.

Increased Financial Strength: Overall, forfeited shares can give the company more funds and help it become financially stronger and more flexible. 

Difference between forfeiture and surrender of shares

Forfeiture of shares happens when a company cancels shares because the shareholder has not paid for them. On the other hand, surrendering shares is when shareholders return their shares to the company to cancel them.

Surrendering shares can be a quicker way to avoid forfeiture. If shareholders are at risk of forfeiture because they have not paid, they can choose to surrender their shares voluntarily.

The company will accept these surrendered shares only if the company’s rules, listed in the Articles of Association (AoA), allow for it.

Journal entry forfeiture of shares at Premium:

Imagine a company issues 100 shares, each priced at ₹120. This price includes a face value of ₹100 and an extra ₹20 as a premium. A shareholder buys some shares and pays ₹70, which covers ₹50 for the face value and ₹20 for the premium. However, the shareholder fails to pay the remaining ₹50 when the final payment is due.

If the company decides to forfeit the shares, it means the shares will be cancelled because the shareholder failed to pay the final amount. 

Note: 100 shares were forfeited because the final payment was not made. Each share had a face value of ₹100 and a premium of ₹20, with ₹50 per share still unpaid.

Factors to consider before you invest

Whenever shares are forfeited, the shareholder loses their ownership, and the shares go back to the company. For instance, if an employee leaves the company before their stock options are fully vested, they lose those options. Investors also lose any money they paid for the shares and do not make any profit. The company can then sell these forfeited shares to someone else, often at a lower price, because they gave up part of the original payment. This applies to both listed and private companies.