ESPP: The Ugly Duckling?

We’ve all heard some version of Hans Christian Andersen’s “The Ugly Duckling" at some point in our lives. For the record, the original is sadder and more intense than I remember. The summary is this. A bird is hatched. It is ugly and misunderstood. Others ostracize it without even knowing what it is. It doesn't fit well anywhere and often has to make its way. Later it grows into a beautiful swan, and everyone admires it. The end.

Welcome to the world of Employee Stock Purchase Plans (ESPPs). If you are at a company that is not publicly traded or is unlikely to ever have an IPO, this post may be less relevant than others. One of the many reasons ESPPs are so misunderstood is that they do not work well for privately held companies.

ESPP are an ugly duckling in the world of compensation, or benefits, or payroll, or HR, or stock administration. The fact that they do not elegantly and easily fall into any single area is proof of their misshapen, clumsy bodies and inability to look and act like any other pay or benefits tool. But, when ESPPs are nurtured they can grow into something beautiful. And, when people are properly educated about them, the odd features and awkward start can still result in something special.

ESPPs are a truly unique compensation element.

1. They offer participants the avoidance of ordinary income and associated taxes.
2. Even when there is ordinary income, the company avoids associated tax withholding (*but may still get the tax deduction.)
3. ESPPs are broad-based by design, but a good plan designer can make them more or less appealing for everyone, or just a limited percentage of your staff.
4. They are ideal for part-time employees.
5. But, you can also exclude part-time employees.
6. Like a 401k, they generally require a contribution from the individual employee.
7. Unlike a 401k, they do not reduce pre-tax income.
8. Amounts contributed usually go directly to a company’s general funds to be used as they see fit.
9. They can be very short-term, with purchase periods happening monthly or even more frequently.
10. They can be very long-term with great discounts covering periods of 24 months and good discounts covering periods of up to 5 years.
11. They usually require the individual to commit a piece of their cash compensation, to then be managed via payroll deductions, to then be administered and delivered as stock-based compensation.
12. They are almost never included in detailed compensation survey data due to the voluntary nature of the programs and wildly different terms and conditions between companies.
13. They require employees to put skin in the game and invest like owners (even though they do offer a nice discount that many other shareholders will not get.)
14. They can be designed to improve any or all of attraction, retention, motivation and engagement.
15. They can be a cultural touchstone or just another tool in your toolbox.

The list above can go on, but this article has some space limitations., So back to our ugly duckling metaphor.

Due to their hybrid structure and incredible design flexibility, ESPPs don’t look the same from company to company. The technical details of the tax and stock components often make them unappealing to those with cash compensation expertise. The required communications and eventual stock delivery can make them a bit of a non-starter for Payroll. Their link to base pay, company strategy and culture can often mean that they are not fully actualized by a stock administration department (or outsourcing provider.)

But, when all of the above come together you have a program that can do a combination of things that no other program can attempt. They can get people to care about company performance. They can help people understand the links between their base pay, short-term incentives and stock ownership or wealth-building activities. They can provide a monetary and cultural link that lowers the churn of your part-time staff. They can fill the hole left when your company had to allocate less stock to mid and lower-level staff as your executive compensation needs grew. In short, ESPPs can be a beautiful swan that can quietly wow and impress your staff.

I will be writing additional articles on this topic over the next few months. If there is something specific you want to learn, please make a note in the comments section.

Dan Walter, CECP, CEP is the President and CEO of Performensation. He is passionately committed to aligning pay with company strategy and culture and considered a leading expert on equity compensation issues. Dan has written several industry resources including a recent Performance-Based Equity Compensation issue brief. He has co-authored ”Everything You Do In Compensation is Communication”, “The Decision Makers Guide to Equity Compensation”, “Equity Alternatives” and other books. Connect with Dan on LinkedIn. Or, follow him on Twitter at @Performensation.

Comments

[Brett Hawkes]

Great reminder, Dan. Thanks for the post. I'd love to see how you might use a variant of an ESPP, or some other vehicle, to garner similar benefits for privately held companies- especially those with no intention of going public.

[Dan Walter]

Thanks for the comment Brett. ESPPs at private companies are far more difficult when designed in a payroll deduction model.

There are a few ways (if you are careful) to create similar offerings or offerings with potentially similar benefits.

1) Create an "incentive pool" for each individual that is based on a percentage of their pay. Allow individuals to exchange "incentive dollars" for cash at a 1:1 value ratio and for RSUs at a discount value ratio. The RSUs can settle in stock, or cash (most likely cash for companies that intend to stay private). This type of plan would cost more for the company and have less tax advantage for the individual, but would give a similar opportunity

2) Consider granting stock options under IRC 423. This is the actual intent of that section of the code. You can grant a stock option with a 5 year life that offers a 15% discount from the value on the purchase date. If a company offered a 2 year life this may be a way to create ownership for those who want it.

3) There are many creative ways to use synthetic equity, like SARs. None will offer the great income/tax benefits of an IRC 423 ESPP, but they can be structured to match a private companies goals more effectively.

Private company equity is a different world. There are some real restrictions, but also some fantastic benefits when designing a plan for a company that has no intent of an impending IPO. I do a lot of work for companies like this and there are few times when two companies end up with the same program.