Weighing the Pros and Cons of ESPP Features
November 17, 2022
What’s not to like about ESPPs? These plans offer a great benefit and promote widespread employee ownership. But once you have decided to implement an ESPP, there are lots of decisions to make regarding the specific features your ESPP will offer.
I recently recorded a podcast with Liz Stoudt and Robyn Shutak of Infinite Equity, in which we debate the merits of four ESPP features: tax qualification, fractional share purchases, cashless participation, and lookback provisions. This blog summarizes our conversation.
For companies that want to offer an ESPP in the United States, there are two choices: a Section 423 qualified ESPP, which offers preferential tax treatment to employees or a nonqualified plan, which does not offer any tax preference. Among companies that offer ESPPs, 80% offer qualified plans.
Given this fact, it seems like that must be the right answer for any company looking to implement an ESPP. 80% of companies can’t be wrong—can they? I’m not so sure, though. I asked Liz and Robyn for their thoughts on the merits of nonqualified ESPPs.
Liz pointed out that one of the reasons qualified ESPPs are so popular is that almost 20 years ago, before FAS 123(R) was adopted, qualified ESPPs were free to the sponsoring corporation. They were considered noncompensatory for accounting purposes simply by virtue of meeting the tax qualification requirements, so they did not result in an expense in the company’s P&L. That is a powerful argument for a qualified plan that is no longer applicable today.
But qualified plans still have the benefit of momentum from that time period. Companies that are implementing an ESPP today see that their peers have qualified plans and assume that they should have one too.
Liz points out that nonqualified plans offer a lot more flexibility, which gives them the following advantages:
- A nonqualified plan can offer a contribution or share match, instead of a discount and/or lookback. While economically equivalent, matches are often easier for employees to understand.
- Nonqualified plans can offer benefits to participants that exceed what is permissible under Section 423.
- Participants in nonqualified plans don’t have to receive equal treatment. The plan can be geared towards employees who don’t already receive equity.
In Liz’s words:
You can really target the bottom portion of your workforce to have greater benefits to encourage them to participate in the plan.
Of course, there are advantages to qualified plans. Robyn points out that the preferential tax treatment, which allows participants to defer taxation until they sell the shares acquired under the plan, is valuable. It also makes the plan easier to administer because the company is not required to withhold US federal taxes on purchases under it—that alone is a deciding factor for many stock plan administrators.
Fractional Share Purchases
Under most ESPPs, employees can only purchase whole shares. But, these days, many brokers and plan administrators have the capability to support fractional share purchases. I asked Robyn and Liz if companies should take advantage of this technology.
Robyn says she is all in on fractional share purchases. She points out that this allows employees to apply the full amount of their contributions to the purchase and eases administration because there aren’t any leftover contributions that have to be refunded or carried forward to the next purchase period.
Robyn also notes that, for companies with high stock prices, lower paid employees may not be able to contribute sufficient funds to purchase a whole share. This can inadvertently exclude many employees who are technically eligible to participate in the plan.
Robyn points out that:
Allowing employees to purchase fractional shares can be the difference between [lower paid] employees participating or not. And to me that's very compelling.
Liz also is generally in favor of fractional share purchases, but she points out that there are some drawbacks. Before allowing employees to purchase fractional shares, it is important to verify that your broker can support them. And employees may be confused about how the fractions work and how they are sold.
I’ll also note that if some participants will purchase less than a whole share (i.e., an “unanchored fraction”), you’ll want to confirm that they can hold the fractional share in their brokerage account. Some brokers automatically liquidate any accounts with less than a whole share.
Since Section 423 was enacted in the 1960’s, ESPPs have been almost exclusively designed to require employees to fund their purchases through payroll deductions. Recently, however, a new funding mechanism has emerged that allows employees to fund their purchases by selling some of the shares they are purchasing. This is very similar to how option exercises are traditionally funded.
Typically, employees are still required to contribute some of their own funds but, with the cashless participation feature, their sale proceeds augment their own contributions. For example, in a plan that caps contributions at 10% of pay, an employee might enroll at a contribution rate of 1% and then sell enough shares to raise funds equaling 9% of their pay, bringing their total contribution up to 10% of their pay. For employees who live paycheck-to-paycheck or have competing financial obligations and goals, this can help them participate in the ESPP on an equal footing with their less financially stressed peers.
It seems surprising to me that it’s taken six decades for this innovation in ESPPs to emerge, but I wanted to know what Liz and Robyn think about it.
I think it’s fair to say that both are in favor of cashless participation. Robyn calls it a "game changer," citing the following examples:
One company using cashless ESPP stated that eight out of 10 plan participants were set to become first time company shareholders--that's amazing! And another company increased its enrollment from 50% to its executive target of 90% in its first cashless ESPP enrollment. Those are really compelling numbers in my mind.
Robyn also points out that cashless participation has the potential to help millions of workers who face limited wage growth, have difficulty saving, and who otherwise would lose out on the chance to participate in their company's equity program.
It’s hard to argue with those points and Liz doesn’t try to. But she points out that CFOs—who are charged with managing plan cost and dilution—often aren’t so easily persuaded. More employees participating at higher rates means more shares will be issued, the company is going to burn through its plan reserve faster, and the plan will be more expensive. Plus, shares are being immediately sold to cover the cost of the purchases, resulting in disqualifying dispositions. And it can be administratively challenging to be at the forefront of innovation.
For our last topic, we discuss the merits of lookback provisions. In ESPPs that have a lookback provision, the purchase price is calculated by comparing the FMV on the purchase date to the FMV at the start of the offering and then applying a discount to the lower of those two values. If the stock price appreciates during the offering, this can produce some very significant gains for participants. This isn’t a new idea: the concept of a lookback is clearly permitted in Section 423 and, among companies that offer tax qualified ESPPs, a little over 60% have a lookback in their plan.
Both Liz and Robyn (and I) have experienced the economic benefits of lookback provisions, which perhaps makes us all a little biased. Liz once experienced a 60% return over a six-month period because the ESPP she was participating in offered a lookback. There isn’t any other investment vehicle that can deliver that kind of return with the same risk profile of an ESPP.
Liz also notes that the lookback provides a buffer against market volatility, which can be important to employees who aren’t in a position to bear the risk of paying market price for the stock. In addition, the lookback magnifies the benefit of the qualified tax treatment; not only can it deliver a phenomenal return, but, when employees hold the stock long enough to satisfy the statutory holding period, most of the gain is taxed as long-term capital gains. Finally, Liz believes that a lookback can be an important driver of participation in the plan.
Robyn points out, however, that lookbacks are expensive. For companies that are concerned about the cost of their ESPP, eliminating the lookback is likely to deliver the most cost savings. And, if the stock price declines over the offering period, the additional cost of the lookback doesn’t deliver a commensurate return for employees; it’s simply a waste of money.
What are my opinions on all these questions? You’ll have to listen to the podcast to find out. I really enjoyed my conversation with Robyn and Liz and I hope you do too.