For private companies, implementing an employee stock purchase plan (ESPP) as part of their compensation plan can facilitate broad-based employee stock ownership.
ESPPs provide a structured way for employees to purchase company shares at periodic intervals, often at a discounted price. Employees contribute through convenient payroll deductions, then stock is purchased from the company on a quarterly, semi-annual or annual basis.
The ability to buy shares at say a 15% discount compared to the fair market value incentivizes participation. Employees also share in the growth and success of the company as the stock value appreciates over time.
While ESPPs have potential benefits for promoting an ownership culture, private companies face challenges determining stock fair value and managing the administrative complexity. Alternatives like phantom equity are worth considering.
Let’s explore how ESPPs work, potential benefits, considerations for private firms, and alternatives to evaluate.
Table of Contents:
- How Do ESPPs Work?
- Potential Benefits of ESPPs
- Considerations for Private Company ESPPs
- Alternatives Like Phantom Equity Your Next Steps in Evaluating Your Company’s Employee Stock Purchase Plan
How Do ESPPs Work?
ESPPs provide a structured framework for employees to steadily purchase company stock over time through convenient payroll deductions. Key elements include:
Employees contribute via payroll deductions to purchase stock
Employees enroll in the ESPP and elect to have a portion of their compensation deducted, usually 1-10%, to go towards buying company stock.
These contributions are made on an after-tax basis from each paycheck, unlike 401(k) contributions. The after-tax treatment provides future capital gains tax treatment upon selling the shares.
Stock purchased at regular intervals (quarterly, annually, etc)
The employee payroll contributions accumulate over an offering period, usually 6-24 months long, at the end of which the accumulated funds are used to purchase company stock.
Common offering period lengths are quarterly (3 months), semi-annual (6 months) or annual (12 months). Offering periods restart routinely, for example a new 3-month offering period starts each quarter.
Purchase price at discount from fair market value (often 15%)
A key feature of ESPPs is the ability to purchase company stock at a discount, which provides valuable incentive for employees to participate. The discount is typically 10-15% below the fair market value of the shares.
For example, if the stock value is $10 per share, the ESPP purchase price may be set at $8.50, allowing employees to buy shares at a 15% discount.
Contribution limits and offering periods specified
To manage dilution, ESPPs specify the maximum employee contribution as a percentage of compensation, for example 10%. Some also have annual dollar contribution caps, such as $25,000 per employee.
The offering periods dictate the frequency of stock purchases. These parameters allow controlling the pace of issuing shares.
Potential Benefits of ESPPs
ESPPs provide a range of potential benefits for companies and employees when thoughtfully designed and communicated:
Promote employee ownership culture
By participating in the ESPP, employees develop a shared sense of ownership in the company rather than just feeling like another worker.
Owning a piece of the business motivates employees to care more deeply about the company's performance and mission. This drives an "owner mindset" across the broader organization.
Align employees with shareholders
Owning company stock intrinsically aligns employees with outside shareholders, as both parties benefit from share price appreciation.
Employees are incentivized to increase efficiency, productivity, customer satisfaction, and other value drivers that will build equity value over time.
Let employees share in company growth
Through ESPP stock purchases, employees participate financially in the company's growth and success.
As revenue, profits, and market share grow, stock values typically follow. Appreciation of ESPP shares enables employees to share in the wealth creation they help generate.
Low risk for employees with purchase discounts
The ability to buy shares at say a 15% discount provides some downside protection for employees. Even moderate declines in the share price often means the employee paid below fair market value. The discounts provide employees great upside with lower risk.
Little dilution for private company owners
Prudent plan design elements like periodic purchases, contribution limits, and reasonable discounts allow controlling share issuances. ESPPs do create some dilution, but it can be gradual and measured through smart program parameters.
Considerations for Private Company ESPPs
While ESPPs have benefits, private companies should evaluate a few key factors:
1. Setting fair market value for stock purchasesPrivate companies must determine the stock's fair value, often using independent valuations, to set purchase prices. This is crucial for both offering discounts and tax compliance.
- Communicating details effectively to employees
The mechanics and potential benefits of ESPPs must be communicated clearly so employees understand the opportunity. Participation rates tend to be higher with education. - Accounting rules for ESPP compensation expense
Companies take a compensation charge under GAAP for the discount on shares purchased. This must be factored into budgeting and projections. - Lower perceived value vs. options/RSUs
Employees may not recognize the full benefits relative to other equity programs. The incentives and retention value may be reduced somewhat. - Administrative overhead to run program
There are costs for stock valuation, record-keeping, brokerage services, communications and other program administration requirements.
While the employee ownership benefits can be powerful, private companies should ensure they have the operational infrastructure and financial resources to implement and maintain an ESPP successfully.
Alternatives Like Phantom Equity
Instead of ESPPs, some businesses should consider exploring alternatives like phantom equity. Here’s how they compare with traditional ESPPs.
Avoid challenges determining fair market values
ESPP Challenge: With ESPPs, there's often a defined purchase period where the stock is acquired at a discount from its FMV. This necessitates periodic valuation to determine the appropriate discount and ensure compliance.
Phantom Equity Solution: Since phantom equity doesn't involve the transfer of actual shares, but rather a promise to pay a bonus equivalent to the value of a set number of shares, there's no need for regular appraisals of FMV. This can streamline administrative tasks and reduce costs.
Provide similar incentives with less complexity
ESPP Complexity: ESPPs, especially for private companies, can involve intricate administration. Ensuring that all employees have equal access, managing the purchase periods, and dealing with post-purchase holding periods can be cumbersome.
Phantom Equity Simplicity: Phantom equity offers the financial upside of stock appreciation without actual stock ownership. The administrative load is often lighter, with no need to manage actual share purchases, holding periods, or the intricacies of shareholder rights.
Enable flexible vesting terms tied to performance
ESPP Standard Approach: Most ESPPs have a fixed schedule for when employees can purchase stock, typically not tied directly to individual performance metrics.
Phantom Equity Flexibility: Phantom equity arrangements can be designed to align payouts with specific performance milestones or company objectives. This ensures that key employees are rewarded directly for driving company success, allowing for a more tailored incentive structure.
Your Next Steps in Evaluating Your Company’s Employee Stock Purchase Plan
Employee Stock Purchase Plans (ESPPs) offer employees a stake in the company, boosting commitment and morale. However, they come with challenges, including balancing costs and managing potential dilution.
Given these complexities, it's critical to consult experts when setting up such a program. If you're considering equity compensation options, a firm like Instrumental Wealth can help you think through the pros and cons of each type. Reach out to book a meeting on one of our advisor team’s calendars here.