MA: To start, can you provide some background on Employee Stock Purchase Plans (ESPPs)?
JF: An ESPP is a type of equity plan that provides eligible employees the ability to buy their employer’s stock at a discount through accumulated payroll deductions. These predetermined payroll withdrawals are after-tax deductions, which are held and accumulated over a period of time. At a specified date, employees automatically purchase stock at a discounted price.
ESPPs are typically categorized into two types: tax-qualified and non-tax-qualified. As the description suggests, the benefit of a qualified plan is that employees receive more favorable tax treatment upon the sale of their shares. If certain requirements are met, gains on the shares will be taxed at the more favorable long-term capital gain rates for employees in the U.S. (the discount will still be taxed as ordinary income).
A nonqualified plan does not provide for any preferential tax treatment, but allows for more flexibility in the terms — for example, exclusion of certain employees. Generally, the nonqualified plan is used in combination with the qualified plan to offer non-U.S. employees the opportunity to purchase stock at a discount (it may be possible to achieve a tax benefit under the tax laws of a particular country).
It is also important to note that an ESPP can be offered to employees of private companies. The tax benefits (under Section 423) are the same — however, liquidity can be a challenge.
MA: Can you talk more about the benefits of an ESPP?
JF: Under a tax-qualified Section 423 plan, participants can purchase stock — up to a maximum discount of 15% — to be computed using a lookback provision. This condition simply allows for the participant to purchase the stock using the fair market value price either at the beginning of the offering period or at the end of the purchase period, whichever is lower.
Let’s say you purchase the stock at 15% off the lesser of the beginning of the offering or the end of the offering. If the stock doubles in value, for example, $10 at the beginning of the initial offering and $20 at the end, you get to pay $8.50 for a share of stock that could be sold for $20.
One of the key benefits of a qualified plan is that the purchase of the stock at the end of the offer period is not a tax event. Such a plan allows an employee to use after tax dollars to purchase stock at a discount without any tax implications. The tax event occurs upon the sale of the share later.
Another benefit of an ESPP is that it allows employees the opportunity to acquire ownership in the company at a discount. A regular equity plan may not extend to all employees, whereas an ESPP allows every employee in the company to choose to purchase stock, with just a few exceptions.
MA: So how does participation in an ESPP work?
JF: Under IRS rules, all employees at a company are eligible to participate in a tax-qualified ESPP, subject to certain allowable exclusions. The concept is that all employees are treated the same in terms of the ability to participate in the ESPP. However, as I noted, some exceptions apply. ESPPs are permitted to exclude those who have been employed at the company for less than two years, those who work 20 hours or less per week, and those who work less than five months out of the calendar year. Employees who don’t live in the US can be included or excluded (normally, they will be excluded from the qualified offering and included in a nonqualified offering to avoid any complication under the qualified offering in the U.S.).
The design of the plan also dictates a participant must be enrolled at the beginning of the offering period and at the end of the purchase period to be able to purchase shares during the qualified period.
There are some statutory rules that limit participation in the ESPP: (i) any employee whose stock and stock options represent 5% or more of the currently outstanding is not permitted to participate in the plan; and (ii) there is a dollar limit ($25,000) on how much an individual can purchase during any year in which an offering is open.
In addition, if the company has operations outside of the U.S., the rules may not be the same. Depending on the laws, costs and administration involved in establishing and maintaining the plan, the ESPP may have to be adjusted for each particular country. It will mirror the same terms as the U.S. offering, but the key difference is the offering will be nonqualified because the participant isn’t getting preferential tax treatment from the U.S. government.
MA: So how does an employer go about implementing an ESPP?
JF: An ESPP can be designed during the pre-IPO phase of a company as they prepare to go from private to public. I’ll highlight some of the principle features involved in putting an ESPP in place, but it is important to note that every plan is slightly different. In the initial phase, the Board of Directors or a compensation committee will approve the plan document, which generally provides for maximum flexibility in terms of plan design along with any requirement that needs to be included to satisfy the qualified plan rules.
Once a plan is in place and adopted, the employer will implement the ESPP by setting the specific terms for an offer through an offering document. The offering document allows for maximum flexibility in the terms of a specific offering. For example, the plan could allow for the maximum 15% discount with a lookback period of up to 27 months, but the offering document may only provide for a 10% discount and a 6 month lookback period. The employer could then modify this in the future — the plan allows for any provision that would be permitted under the regulations and still be a qualified plan, but the offering document reflects the economic terms that have been approved by the company. This allows for flexibility in different offerings without the need to go back to the shareholders for approval of design changes in the plan.
One additional consideration for the adoption of an ESPP in connection with an IPO is the share reserve, which is the number of shares that can be issued under the plan without going back to the shareholders for an increase. Normally, there will be an initial share reserve, but in connection with the IPO the company will include an evergreen provision that automatically adds shares each year without the need for additional shareholder approval. Normally it’s a 1-2% initial reserve; however, the evergreen often amounts to another 1% being added each year going forward. From the IRS’ perspective, employers also have to have a hard cap, so it’s usually a lesser of 1%, a fixed number, which is 1% at the time you’re putting the plan in place, or such amount as determined by the board.
Once the evergreen provision is accepted, an S-8 is filed. This is a registration statement that allows companies to issue shares to employees. Participants are then issued a prospectus. This summarizes what the ESPP is, the material terms and the tax implications. This is usually an easy-to-read Q&A or FAQ offered to all participants.
The final step is the enrollment process. As participation in the ESPP is an investment decision, the S-8 needs to be filed before participants can make an election to participate. To address the timing lag, in particular in an IPO, some plans auto enroll participants in the ESPP at the time of the IPO or the introduction of the plan so employees can receive the benefit of the IPO price as the lookback price. Once the S-8 is filed, then participants can elect to stay in or elect to “opt out” at that time, but anyone who elects to participate will have the benefit of the IPO price as the lookback. One thing to keep in mind, however, is that if the employee doesn’t want to participate in the ESPP, or they don’t complete their paperwork by a specific time, they are withdrawn from the ESPP and are no longer a participant.
MA: How do you communicate the value of ESPPs and maximize participation?
JF: Employee communication and education are key to a successful equity compensation arrangement. To maximize plan participation, it’s important to ensure that employees have a solid understanding of the plan’s design, its benefits and the advantages of long-term stock ownership.
The participation rate in an ESPP varies depending on the terms of the plan including the length of the purchase period and the purchase discount. If at least 20% of a company’s total eligible employee population participates in the ESPP, it’s typically deemed a success.
When it comes to best-practice participant communications, it really begins with education. Usually the benefits administrator or, in some instances HR, takes an active lead to educate and distribute materials. Often a company will host a benefits fair to give employees an opportunity to discuss details of the plan one-on-one. Technology is also another important channel to promote the plan. Materials are distributed via all electronic devices, including computers, laptops, tablets and smartphones.
To conclude, ESPPs offer a great benefit to employees, so it is essential to communicate effectively during every stage of the process so they can take full advantage.
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