Are You Overvaluing Your ESPP?
September 23, 2019
As I’m sure my readers know, under ASC 718, the fair value of an ESPP comprises three components, each of which is valued separately. But what you might not be aware of is that additional discounts can be built into the fair value calculation.
A recent article from consulting firm Infinite Equity contends that the standard valuation approach for a typical ESPP with a 15% discount and a lookback overestimates the actual fair value (“ ESPP Valuation: 4 Missing Pieces,” Jon Burg and Carly Sanfilipo, June 2019). Jon and Carly believe there are unconsidered ESPP design features that can reduce fair value—in some cases by as much as 25%.
It is largely unheard of for ESPPs to accrue interest on contributions, which means that participants do not earn the return that they otherwise could if their contributions were invested in an interest-bearing account. This reduces the value of their participation in the ESPP and, as a result, can reduce each offering’s fair value for ASC 718 purposes—possibly by as much as 1% to 2%.
Where plan limitations may curtail the number of shares employees can purchase, this also can reduce the grant date fair value of each offering. The FASB’s standard approach to valuing ESPPs (referred to as “Solution 1” in the article) essentially assumes that employees can purchase an infinite number of shares, regardless of what happens to the company’s stock price. In real life, this is never the case.
A more sophisticated approach to valuation takes into account any possible limitations and reduces the fair value accordingly.
Ditto everything I just said for the $25,000 limit that applies to Section 423 ESPPs.
Finally, a new type of ESPP that we are hearing about lately (referred to as a Carver Edison ESPP—more on this in a future blog entry), allows employees to participate in an ESPP on a cashless basis (similar to a sell-to-cover exercise of a stock option). In this plan, a portion of the shares purchased are sold to cover the purchase price and the gain on the net shares sold is capped (in lieu of a transaction fee on the sale). This cap can also reduce the fair value of the ESPP.
Want to know more about these reductions to fair value? Check out the white paper “ ESPP Valuation: 4 Missing Pieces” by Jon Burg and Carly Sanfilipo of Infinite Equity.- Barbara