Today I wanted to briefly discuss my favorite form of Equity Compensation. It is the Employee Stock Purchase Plan (ESPP). Why is it my favorite? Because just about everyone can participate in this type of savings plan. About the only exemptions are those who are brand new employees and part-time employees too. Basically, if you are a full-time employee you are eligible to participate in this wonderful benefit.
As always, let’s start with the foundation. And just to be clear, I’m talking today about an Employee Stock Purchase Plan, not an ESOP, which is an Employee Stock Ownership Plan and is a retirement style plan. These are two different animals and I will only be covering the former.
Alright, back on topic. An ESPP is a great vehicle to allow employees to purchase employer stock and hopefully at a discount. The advantage is you get to buy stock of the company you work for at a price that is lower than if you went out and bought it on your own.
When you participate in an ESPP your investments are held in a regular old investment account. It is not held in a retirement-type account, such as a 401k. Part of the reason they are kept in a regular account is there may be special rules applicable for a sale or disposition if you bought the shares at a discount.
Employee stock purchase plans can be either Qualified or Non-Qualified. Qualified versions simply mean they have met certain requirements laid out by tax law. They are sometimes called Section 423 plans as this is the part of the Internal Revenue Code that speaks to ESPP. Now, if an ESPP is a Qualified plan it can then offer some nice tax-advantaged treatment. On the flip side, non-qualified plans do not have to meet these requirements and provide no special tax treatment.
You’ll often hear people mixing ISOs (incentive stock options) and ESPPs up. It is easy to confuse them as some of the rules for these two types of equity compensation plans are the same. However, there are some key differences and I would be remiss if I didn’t point out some of the key ones.
First, while an ISO has to be priced at or above the price of the stock when it is granted, ESPPs can be offered at a discount of up to 15%.
Next, ISOs are frequently limited to certain employees, such as higher-level executives. ESPPs have to be available to every employee with only a few exclusions, such as brand new and/or part-time employees.
AMT applies to ISOs but not to ESPPs. On the flip side, ISOs have a bit more tax benefits as you may be able to convert their entire profit into long-term capital gains, while portions of ESPP gains may be classified as compensation income.
Enough of that background on the differences between ISOs and ESPPs. Let’s get onto how ESPPs operate. I will be mixing in some definitions and terms you should be familiar with if you participate in an employer stock purchase plan.
As always, plan specifics differ from employer to employer. So, be sure to talk to your benefits people to make sure you have the right information for your ESPP. But let’s talk about some of the more common terms and themes across most employee stock purchase plans.
First, most plans have an Offering Period. This is when you have to decide whether to participate in an ESPP. If you decide to participate, you have to sign up by a particular date and have a set amount withheld from your pay to purchase the company stock during this offering period. Withholding amounts range from 1% to 10% of your pay.
During this offering period, your payroll deduction will accumulate in your account and at the end of the period it will be used to buy the company stock at a price equal up to 85% of the lower of the stock value at the beginning or the end of the offering period. Let’s go through a quick example. If the company stock is $10 at the beginning of the period and $12 at the end of the period, the purchase price will be $8.50 or a 30% discount from the $12 price when purchased. Now, most ESPPs simply set the purchase price at 85% of the stock’s actual price at the end of the offering period, but this is where it is key to know your plan specifics.
Many plans will allow you an out. So, if at some point during the offering period you decide not to execute your ESPP and buy the company stock at a discounted price, you may be able to get your contributions back. Plans have deadlines for these decisions and they are often several weeks before the end of the offering period.
Something important to mention – companies do not have to offer a 15% discount. They can offer a smaller discount or none at all. Even with no discount, you may still come out ahead if your ESPP permits you to buy the company stock at the price at the beginning of the offering period vs the end. Following the same example as before, if the beginning price is $10 and the end price is $12, you may be able to buy it at $10, or a 20% discount.
Hopefully you understand why I love ESPPs so much. Lots of advantages to these plans for participants and the fact just about everyone can participate, from the highest level to the most entry level position in the company now has a way to tie directly to their company’s success.