You may have been told that it isn’t possible to issue shares of stock in fractional amounts. While this technically may be true, in today’s digital world, it is possible for stock plan participants to accrue shares in fractional amounts. Over time, the fractions accumulate into whole shares that increase the value delivered to participants under your equity plans.
Most brokers offer their clients the opportunity to participate in dividend reinvestment programs (DRIPs). When investors enroll in a DRIP, the broker automatically applies any cash dividends they receive on their stock to the purchase of additional stock. These purchases invariably involve the acquisition of a fractional amount of shares each time a dividend is paid.
The same processes that enable investors enrolled in DRIPs to accrue and sell fractional shares can be leveraged to enable fractional share acquisitions in company stock plans.
ESPPs are one area where fractional shares can be very useful. If your stock price is appreciating, allowing fractional shares provides a greater economic benefit to employees than simply carrying forward their unused contributions.
If the employee purchases fractional shares, the employee will acquire 16.666 shares in the first purchase period ($2,000 in contributions divided by $120) and 14.286 shares in the second period ($2,000 in contributions divided by $140). The employee ends up with 30.952 shares that are currently worth $4,952 and change.
Without fractions, however, the employee only purchases 16 shares in the first purchase period and carries forward $80 in unused contributions to the second period ($2,000 in contributions less total purchase price of $1,920). In the second purchase period, the employee buys 14 shares ($2,080 in contributions divided by $140 and rounded down to the nearest whole share) and has $40 of unused contributions leftover ($2,080 in contributions less total purchase price of $1,960).
In the scenario without fractions, the value of the employee’s total holdings is only $4,920 (30 shares of stock worth $4,800 plus unused contributions of $120). The employee who purchases fractional shares is ahead by $32. This might not seem like much, but over time it can add up.
Fractional shares can also be useful with RSUs, particularly when employees have small increments of shares vesting and shares will be withheld to cover the taxes due upon vest. For example, let’s say that an employee has an RSU vesting in four annual increments of two shares each and the company would like to use share withholding to cover the employee’s tax liability.
Without fractional shares, the company must withhold one share from each vesting increment to cover the employee’s taxes. In most cases, the value of the share is likely to exceed the required withholding. In fact, it may even exceed the maximum individual tax rate. If so, the excess must be refunded to the employee; if added to the employee’s tax payment, it would trigger liability treatment under ASC 718. And, the tax withholding eats up fully half of the employee’s shares.
But if a fraction of a share can be withheld, the company can withhold exactly the amount necessary. Let’s say the total withholding rate for the employee is 29.65% (22% FIT, 6.2% Social Security, and 1.45% Medicare). On each vesting date, the company withholds .593 shares and the employee receives 1.407 shares.
When the award has fully vested, the employee has 5.628 shares worth $900.48 (at $160 per share). Without fractions, the employee ends up with only 4 shares worth $640.
Brokers can have different processes for selling the fractions. When an investor sells at least one whole share and a fraction of a share, one approach used by brokers is to pay the investor cash for the fraction at the same price that the whole share is sold at. The broker might then sweep the fraction into an omnibus account, where it is aggregated with fractions from other investor sales. When the fractions add up to a whole share, the broker sells them to recoup the cash paid out to investors for the fractions.
One trap to watch out for is that most brokers cannot support fractions that aren’t “anchored” by a whole share. I used vesting in increments of two shares in my RSU example because the whole strategy may fall apart if each vesting increment is just one share.
In that scenario, the employee would receive just 0.7035 net shares on each vesting date. This is problematic because, when investors don’t have any whole shares in their accounts, most brokers automatically liquidate any remaining fractions. Thus, the employee in our example likely wouldn’t be able to hold .7035 shares in his/her brokerage account.
It sure was. In the example involving the purchase of fractional shares, I rounded all my share amounts down to three decimals. As a result, the employee would have some leftover unused contributions after each purchase that must be refunded or carried forward to the next purchase period ($0.08 in the first purchase period and $0.04 in the second). You can’t just ignore those amounts, even though they might be small. Unless you carry the decimals out until infinity (which probably isn’t possible due to systems limitations), there will always be some leftover unused contributions that you have to manage.
The Power Session “Why Fractional Shares Matter” at this year’s NASPP Conference will explore why fractional shares deserve a second look for your equity plan, as well as key considerations to think about before you make the switch.
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