Compensation Thought Leadership
2012Q4 - PLAN DESIGN
Plan Design: Employee Stock Purchase Plan (ESPP) Myths and Truths
The expensing of share-­‐based compensa/on, required by ASC 718, has had many unintended vic/ms, including many broad-­‐
based equity programs. The most unfortunate of these vic/ms are employee stock purchase plans (ESPPs) that are tax-­‐
qualified under Internal Revenue Code (IRC) Sec/on 423. Historically, these programs have been implemented to spur employee ownership and company alignment through discounted stock prices and tax benefits for holding shares over the long term. The past several years have changed the popularity of ESPPs, and companies have been reluctant to move back to historic norms. This is largely due to myths about cri/cal cost, engagement, and shareholder concerns.
The plans are typically funded by employee payroll deduc/ons. All full-­‐/me employees must be allowed to par/cipate if the plan is an IRC 423 ESPP. Many companies also allow most or all part-­‐/me employees to join. These plans generally buy shares for employees at a 15% discount every three months or six months. In most cases, the purchase price is based on the lower of the company’s stock price on the first or last day of the period. This plan design feature is called a look-­‐back. Some companies design plans with long offering periods that allow the look-­‐back to go as long as two years. Employees also benefit from a managed purchase, avoiding the bid/ask spread, and generally having lower transac/on fees. In addi/on to being significantly discounted, shares purchased under these plans are tax advantaged if they are held for at least two years from the beginning of the offering period and at least one year from the date of purchase. In a well-­‐designed and communicated plan, everyone puts something into the plan and everyone gets something out of the plan. In short, the employee puts some “skin in the game” in the form of payroll contribu/ons. The company puts some “skin in the game” in form of administra/ve costs and plan management. The shareholders, who must approve these plans, put some “skin in the game” in the form of future dilu/on. The employees get discounted shares of the company’s stock, which can be used to build stock holdings or to provide a self-­‐made bonus based on the amount of their contribu/ons and the movement of the company’s stock price. The company gets focused and passionate employees who work harder and be[er understand the overall corporate picture. The shareholders get a company whose management and workforce are in sync and focused on increasing the company’s stock price. Everyone seems to win, so where’s the problem?
When designed according to the fairly limited set of rules defined in the IRC, these uniquely American plans offer the li[le guy a chance to contribute and benefit from the success of the company for which he works. In fact, employees who own more than 5% of the vo/ng shares of the company are excluded from par/cipa/on, and par/cipants may only purchase up to $25,000 of company stock for each year that their grant is outstanding. These limita/ons help to ensure that it is very difficult for employees to “get rich” in the way that some people do using stock op/ons. ESPPs promote the basic premise long espoused by proponents of equity compensa/on. Employees should contribute to the cause, act and feel like owners, and eventually they, the company, and its shareholders will benefit.
So, if ESPPs are generally good for employees, companies, and shareholders, why did some companies significantly modify or even eliminate them en/rely? The answer can largely be found in accoun/ng rules. Accoun/ng for share-­‐based compensa/on under U.S. accoun/ng rule ASC 718, and the move to harmonize U.S. and interna/onal accoun/ng rules under IFRS2 affect the way companies view ESPPs. We must first understand how these plans were accounted for historically. Under APB 25, the accoun/ng rule used in the U.S. between the 1970’s and 2005, IRC 423 plans carried no accoun/ng charge. The plans were “non-­‐compensatory” under both the IRS rules and the accoun/ng rules. The updated rules, however, require a company to expense a fair value for share-­‐based plans, including ESPPs that offer a look-­‐back or more than a token discount. The interna/onal rule, IFRS2, is very restric/ve and requires companies to calculate a fair value for each poten/al share to be purchased, even if no discount or look-­‐back period is offered. ©2012 Performensa/on
ASC 718 made two significant changes to the non-­‐compensatory rule for U.S. accoun/ng:
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Any plan with an “op/on-­‐like feature,” such as a look-­‐back period, now results in an expense to the company.
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Any discount that is greater than that offered to the regular shareholders or is more than the standard cost of issuing new shares results in an expense to the company. While a safe harbor provides non-­‐compensatory status for discount of no more than 5% of the share price on the purchase date, the end result of the new rule requires companies to recognize an expense for nearly every effec/ve IRC 423 ESPP.
As companies evaluate the effect of accoun/ng rules on their ESPP, they must deal with several consequences. If a company chooses to modify its plan to be non-­‐compensatory under the rules, they must expect that some, and maybe most, par/cipants will discon/nue par/cipa/on. This will lessen the overall effec/veness of the plan as an ownership tool. If the company chooses to discon/nue their plan, it must be prepared to communicate this change in a way that does not alter the focus or passion of employees. Even non-­‐par/cipants may see the cancella/on of a plan as a nega/ve message from management. If a company chooses NOT to change its plan, it must account for the addi/onal expense the ESPP will create for the company. It must also plan for shareholder response to the associated expense. In this era of shareholder strength and focus on revenue rather than cost, many companies are choosing the path that, on the surface, seems most palatable to shareholders—they are modifying their plans or canceling them altogether. This leads us to the myths and truths about ESPPs.
10 Myths about ESPPs (and the truth behind them):
MYTH 1: The plans are too expensive for companies to run.
TRUTH 1: ESPPs are oHen less expensive than stock opIons and other forms of incenIve compensaIon. Essen/ally, each par/cipant’s elected contribu/ons are converted into a virtual stock op/on grant. Employee stock purchase plans are valued using the same methods as are used to value stock op/ons or other forms of share-­‐based compensa/on. The valua/on methodology is used to create fair value (FV) for each share of the grant. The valua/on models used require the use of at least six inputs, including stock price on the grant date, the grant price itself, the term of the grant, the interest rate and dividend yield for the term of the grant, and the es/mated future vola/lity of the underlying stock. Of these inputs, the two most powerful drivers of FV are expected term and vola/lity. Due to the rela/vely short-­‐term nature of ESPPs, these values are significantly lower than those used for standard stock op/on grants. Even the most generous plans typically offer no more than a two-­‐year term, while most offer less. Data from the Na/onal Associa/on of Stock Plan Professionals (NASPP) 2010 Domes/c Stock Plan Design Survey show that almost half (48%) of all plans allow only a 6-­‐month term and 21% have a 3-­‐month term. Another strong driver of FV is the discount at the /me of grant. This is a significant factor in ESPPs since many plans offer a 15% discount from the grant date price, which may be replaced by a 15% discount from the purchase date price in the event the stock price falls during the term. The NASPP data show that 71% of companies offer a 15% discount and 62% allow a look-­‐back.
The two most powerful drivers of fair value are expected term and volaIlity. Due to the relaIvely short-­‐
term nature ESPPs, these values are significantly lower than those used for standard stock opIon grants. A fact omen missed in analyzing the cost of an ESPP is that par/cipant contribu/ons typically come directly out of payroll and go back into the general funds of the company. Here they can be used as needed un/l the purchase date. In a strong market, these funds can even func/on as a temporary secondary offering or loan from employees to the company. A well-­‐designed ESPP can mean a more flexible opera/ng budget.
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MYTH 2: Shareholders will not conInue to approve new shares for these plans.
TRUTH 2: Shareholders seem to love ESPPs. According to Ins/tu/onal Shareholder Services’ (ISS) proxy vo/ng analy/cs database, shareholders of Russell 3000 companies, since 2006, have approved every one of the nearly 1,000 new and amended plan proposals that company management has put before them. Ins/tu/onal and individual shareholders alike are looking for the best ways to increase shareholder value. Further, they understand the role and importance equity compensa/on plays in achieving these objec/ves. When a company can show convincing reasons for the design of a plan, shareholders have shown that they will approve it. Even the ins/tu/onal shareholders are likely to posi/vely respond to a plan that is well designed and shows a thoughoul approach to company, employee, and shareholder needs.
When a company can show convincing reasons for the design of a plan, shareholders have shown that they will approve it. Russell 3000 ESPP Proposal Approval Rate. Since 2006
100%
Approved
Failed
MYTH 3: Employees do not parIcipate in the plans in a passionate way.
TRUTH 3: ESPP ParIcipants are the passionate employees you want to reward and retain. Many people are surprised to learn that an analysis of purchase plans showed that the average plan par/cipant contributed a significant percentage of annual income. One analysis of these plans performed by a major outsourcing provider showed that par/cipants contributed an average of $4000 annually. Recent surveys show that ESPPs average 17% par/cipa/on for programs with discounts under 15%, and 41% par/cipa/on of eligible employees when the discount is 15%. Many look to the percentage of employee par/cipa/on as a guide to the passion for a plan. While this sta/s/c is a legi/mate measurement, it does not take into account whether there are other investment opportuni/es available to employees, nor does it take into account the specific features of the underlying plans. Of course, there are always a few companies with extremely low par/cipa/on (<10%), but many companies report that they have more than 70% of eligible employees as par/cipants and some report par/cipa/on above 90%.
Why this disparity in par/cipa/on? Many factors come into play. Among them are the historic prices of the underlying stock, the discount offered to par/cipants, the period that the discount is locked in, and the other investment opportuni/es offered to par/cipants. On top of these are perhaps the two most important factors: the general ownership culture within the company and the communica/on programs associated with the plan. These last two factors have li[le to do with the specific plan features and strongly contribute to par/cipants’ percep/on of the company and plan. This is why some companies with modest stock price growth (or decline) and plans with moderate benefits s/ll maintain high par/cipa/on rates, while other companies with generous plans and vola/le stock prices may have very low par/cipa/on even though those shares are poten/ally more valuable.
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Recent surveys show that ESPPs average 17% parIcipaIon for programs with discounts under 15% and 41% parIcipaIon of eligible employees when the discount is 15%.
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MYTH 4: Plans with low parIcipaIon rates are not effecIve.
TRUTH 4: ParIcipaIon rates are a weak measurement of plan effecIveness. Many companies and shareholders use par/cipa/on rates as their guide to whether a plan is effec/ve. Perhaps a be[er guide is whether the core of your essen/al staff is par/cipa/ng in the plan and whether they find the plan valuable in retaining and rewarding. In these /mes of lean staffing, it is more important than ever to keep mo/va/ng essen/al staff members, regardless of their corporate level. They are the motor that keeps a company moving forward. Predictably, as some companies have moved to reduce their plan benefits to meet the non-­‐compensatory rules of ASC 718, they have seen par/cipa/on rates drop precipitously. Many industry professionals have noted anecdotally that they feel the drop-­‐off is in part due to the lack of confidence the company is showing in the underlying stock or the par/cipants themselves. Some of these drop-­‐offs have been seen at companies where strong employee ownership has historically been an unwri[en contract between management and employees. Some believe that employees feel that when a company gives up on the features of the plan, it is also making a statement about the value of the employees as a whole.
An ESPP that strongly engages a limited porIon of your staff may sIll be effecIve in helping your company reach its goals.
In short, the Pareto Principle theorizes that 20% of any group provides 80% of the group’s produc/vity. ESPPs can prove to be an effec/ve tool for keeping this highly produc/ve minority mo/vated and focused.
MYTH 5: Employees flip their shares to make a quick profit.
TRUTH 5: ESPP flipping is less common than believed and offering the potenIal for flipping shares may even increase plan effecIveness. A few major na/onal publica/ons have reported that ESPP par/cipants omen use these plans to par/cipate in stock flipping. The complaint is that par/cipants join the plan, purchase the shares at a discount, and then sell them as soon as possible, ensuring at least a 15% profit. While it is true that some par/cipants do sell their shares soon amer the purchase, the underlying facts should be examined more closely.
1.
Some plans offer a “quick-­‐sale” provision, in which par/cipants can choose to have their shares sold immediately amer they are purchased. In most companies where this feature is offered, most par/cipants choose to hold their shares for months or years amer the purchase. This is true even when the stock price has been flat or moving moderately downward. In a number of cases where companies have added this feature in middle of the life of the plan, par/cipa/on has increased drama/cally. Addi/onally, while some of those addi/onal par/cipants do choose to sell their shares immediately, many choose to hold their shares amer the purchase and become employee-­‐owners, whose goals are easily aligned with those of non-­‐employee shareholders. 2.
In companies that do not offer quick-­‐sale programs but s/ll allow for par/cipants to sell as they choose amer the purchase date, par/cipa/on tends to run a bit lower. However, the vast majority of par/cipants hold some or all of their shares for a significant period amer the purchase date.
Offering the ability to quickly sell shares can increase overall parIcipaIon at a greater pace than the increase in shares sold.
MYTH 6: The plans allow employees to make profits that should be going to the shareholders.
TRUTH 6: Correctly designed ESPPs transfer li[le shareholder value, while providing significant employee impact. Compared with other forms of equity compensa/on, ESPPs are generally minimally dilu/ve. This is especially true in companies with higher stock prices. Remember, par/cipants use their own money to purchase stock. Unlike other equity programs, ESPPs usually put contribu/ons into the general funds of the company, allowing for interim investment and use by the company. As discussed earlier, a properly designed, communicated, and administered plan should benefit all related par/es. Since the goal of shareholders is to increase the value of the company’s stock, and the benefit that par/cipants receive grows as the underlying stock increases in value, the holis/c effect of ESPPs is to mo/vate to all par/es. While it is true that employees do receive a greater dollar-­‐for-­‐dollar benefit than regular shareholders, it has been shown that companies with broad-­‐based ownership programs tend to provide greater overall returns to all shareholders.
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MYTH 7: Trends show that companies have canceled or modified their plans to fit within the non-­‐compensatory safe harbor defined in ASC 718.
TRUTH 7: Many consultants predicted this movement, but the facts do not support this myth. Data from the NASPP show that only 14% of companies have eliminated their ESPP in the past several years. Another 17% offer only a 5% discount, while 34% of companies no longer have a look-­‐back feature. While many companies have modified their plans, far more said they would but then didn’t. Even more encouraging is the increased interest in new plans over the past 18 months. A thoughoul analysis by most companies will show that their ESPPs provide a benefit to employees, company, and shareholders that is difficult if not impossible to replace. Many companies are finding that the results of their ESPPs jus/fy the costs. The expense is insignificant compared to the detrimental cost of discon/nuing the ESPP or replacing it with a less effec/ve one. Companies that have modified their ESPPs have reported significant reduc/ons in par/cipa/on and employee morale. Alterna/vely, companies that stayed the course display increasing evidence of the plans’ benefits. Several recent studies show that it is increasingly likely that companies will move to re-­‐
establish their former plans or rollout new ESPPs with look-­‐back features and more generous discounts. Data show that these plans offer an excellent cost/reward ra/o as a piece of employee compensa/on and mo/va/on, as well as shareholder alignment.
There has recently been increased interest in larger discounts and re-­‐
establishing ESPPs with look-­‐back provisions. These more generous plans have been shown to have more impact at limited increased costs.
MYTH 8: Longer offering periods are not beneficial to shareholders.
TRUTH 8: Longer offering periods actually encourage two key goals of ESPPs. They encourage early employee parIcipaIon as well as increase the company’s ability to a[ract and retain talent.
The poten/al benefit of keeping a grant price for an extended period omen mo/vates par/cipants to join earlier, essen/ally moving them to “buy low.” This concept of buying low and selling high is a keystone concept of inves/ng in company stock. ESPPs help employees become educated members of our ownership-­‐based society and encourage them to think like shareholders. A second benefit of longer offering periods is in employee reten/on. Employees with low long-­‐term grant prices may use the poten/al future value as an addi/onal reason to remain with their current employer, rather than moving to a new job.
MYTH 9: ESPPs are a not a broad-­‐based form of compensaIon based on parIcipaIon.
TRUTH 9: Broad-­‐based compensaIon is typically defined as compensaIon available to at least 50% of a company’s employees. By design, IRC 423 ESPPs fit this definiIon. Of course, par/cipa/on can vary widely depending on plan design, communica/on, corporate culture, and economic factors. Of the companies surveyed by the NASPP, one-­‐quarter had be[er than 50% par/cipa/on. More importantly, half of companies have between 20% and 50% par/cipa/on. Employees who par/cipate in the ESPP become ambassadors for your company’s success. Whether par/cipa/on is 15% or 90%, the employees who do par/cipate show the value of these programs by their willingness to invest in them. To par/cipate, an employee usually must go through the process of enrolling. While this does not take much effort, it is common knowledge that programs that require ini/al interac/on usually have lower par/cipa/on rates than those in which employees are automa/cally enrolled. Employees must also dedicate a por/on of their post-­‐tax, take-­‐home pay. Basically, they must choose between the possibility of making a profit on the company’s stock or using their money to buy or invest as they choose during the same period. Very few compensa/on or incen/ve programs require this level of commitment from rank-­‐and-­‐file employees. While ESPP par/cipa/on may fluctuate as companies’ stock prices go up and down (similar to outside investors’ interest), those who par/cipate tend to be engaged employees.
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MYTH 10: ParIcipants can easily replace their ESPP by parIcipaIon in other types of plans such as restricted stock plans or 401(k) plans.
TRUTH 10: While employees must oHen make a choice between parIcipaIng in a 401(k) program or an ESPP, the two plans offer very different benefits. 401(k) plans are designed as a re/rement device. As a very long-­‐term program, 401(k)s offer li[le access to employee contribu/ons without penalty and they are omen invested in funds that have no personal a[achment for the employee. A 401(k) plan may offer par/cipants a chance to invest in the company’s stock, but the withdrawal limita/ons and generally slow administra/ve turn-­‐around /mes can present employees with unintended risks. ESPPs offer both short-­‐ and long-­‐term possibili/es. More importantly, they have a visceral and personal aspect. Employees can see and experience the company and stock they are inves/ng in. They have the opportunity to change it, move it, and make it successful. This interac/on cannot be offered through a 401(k). This personal investment can make par/cipa/ng in an ESPP a passionate affair. The administra/on of ESPPs is streamlined and the rules governing these plans are not as restric/ve as those for 401(k) plans. This combina/on lowers risk and increases par/cipant interac/on.
EffecIve Uses for ESPP and AlternaIves
ESPPs are a unique compensaIon instrument that bridge the gap between equity compensaIon and benefit programs. The combinaIon of direct employee parIcipaIon, alignment with company metrics and tax advantages provide opportuniIes not available through other means. ESPP
Restricted Stock
401K
Shareholder Alignment Employee Participation
Long-­‐term Incentive
Tax Benefits
In recent years, we have seen a push for restricted stock unit (RSU) plans to replace both stock op/ons and ESPPs as a favored form of broad-­‐based compensa/on. RSUs are, at best, a passive form of par/cipa/on. They are simply given to employees, who then must only keep their jobs un/l the awards vest. ESPPs require an elec/ve and interac/ve form of employee par/cipa/on. RSUs also generally have a higher accoun/ng expense to go with a structure that does less to engage par/cipants. ESPPs and restricted stock plans are vastly different instruments that serve different purposes. While both have their place in a company’s compensa/on poroolio, neither replaces the other.
CONCLUSION
Employee stock purchase plans are a unique form of equity compensa/on that requires an ac/ve partnership between a company, its employees, and its shareholders. Plans must be designed to support specific goals. In turn, these goals and features must be properly communicated to both the employees and shareholders. ESPP par/cipants must be proac/ve in joining a plan and passionate in their long-­‐term par/cipa/on. These plans offer possibili/es not available through other types of compensa/on programs. Even the most generous plans are less expensive for the company than most other forms of equity compensa/on. While the rules for accoun/ng have increased the expense associated with these plans, they have not affected the value that these plans offer to the company, employees, and, ul/mately, shareholders. Companies should carefully evaluate their current plans and determine whether improving, rather than discon/nuing, the plan may be the best path to follow. ESPPs have long offered a unique opportunity to engage employees. That opportunity should not be taken away due to accoun/ng issues.
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©2012 Performensa/on
About the Authors
Performensation
Contacts:
To contact the authors of this ar/cle, please write to Dan Walter, dwalter@performensa/on.com, or Sam Reeve, sreeve@performensa/on.com, at Performensa/on or Jon Burg, [email protected] at Radford, an Aon Hewi[ Company. Dan Walter is President and CEO of Performensa/on and is located in San Francisco, CA. Sam Reeve is an Execu/ve Vice President of Performensa/on and is located in Colorado. Jon Burg is an Associate Partner in Radford’s valua/on prac/ce and is based in San Francisco, CA.
Dan Walter, President and CEO +1 (415) 625-­‐3406 dwalter@performensa/on.com
About PerformensaIon
Since 2006, Performensa/on has focused on providing high performance compensa/on plans for publicly-­‐traded and privately-­‐held companies. As a recognized industry thought leader, we learn as much as possible about your company in order to diagnose the founda/ons of success. We then apply this knowledge to custom-­‐fit solu/ons. We offer a wide range of compensa/on services including ESPP plan design, upgrade and communica/on. Our services deliver structure and messaging that align your goals, culture and vision with holis/c compensa/on programs.
Sam Reeve, EVP
+1 (415) 625-­‐3088 sreeve@performensa/on.com Mel Jameson, EVP
+1 (415) 625-­‐3405 mjameson@performensa/on.com
Radford Contacts:
About Radford
San Francisco Office
Radford is the industry leader, providing advice and benchmarking to technology and life sciences companies to address their toughest HR and rewards challenges: a[rac/ng, engaging and retaining talent. Our advisors provide industry-­‐specific exper/se, applying an analy/cal approach that integrates market data, trends and our experience in working with more than 2,000 companies – from Global 1000 firms to start-­‐ups – to balance the needs of execu/ves, employees and shareholders. Our advice is customized to a client’s unique situa/on to ensure your rewards programs are not just compe//ve -­‐ but can be a compe//ve advantage.
Jon Burg, Associate Partner +1 (415) 486-­‐7137 [email protected]
Radford’s uniquely data-­‐driven perspec/ve is why more technology and life sciences companies, and their Board of Directors and Compensa/on Commi[ee, trust Radford for compensa/on data and advice than any other firm. Radford clients rely upon our global survey databases of nearly five million incumbents for real-­‐/me insight on total compensa/on levels, prac/ces and emerging trends to inform their HR and reward strategies.
Headquartered in San Jose, CA, we have professionals in Bangalore, Beijing, Boston, Brussels, Chicago, Frankfurt, Hong Kong, London, New York, Philadelphia, San Francisco, Shanghai and Singapore. Radford is an Aon Hewi[ company. Visit www.radford.com, or for more informa/on, contact [email protected].
About Aon Hewi[
Aon Hewi[ is the global leader in human resource solu/ons. The company partners with organiza/ons to solve their most complex benefits, talent and related financial challenges, and improve business performance. Aon Hewi[ designs, implements, communicates and administers a wide range of human capital, re/rement, investment management, health care, compensa/on and talent management strategies. With more than 29,000 professionals in 90 countries, Aon Hewi[ makes the world a be[er place to work for clients and their employees. For more informa/on on Aon Hewi[, please visit www.aonhewi[.com.
About Aon
Aon plc (NYSE: AON) is the leading global provider of risk management, insurance and reinsurance brokerage, and human resources solu/ons and outsourcing services. Through its more than 61,000 colleagues worldwide, Aon unites to empower results for clients in over 120 countries via innova/ve and effec/ve risk and people solu/ons and through industry-­‐leading global resources and technical exper/se. Aon has been named repeatedly as the world's best broker, best insurance intermediary, reinsurance intermediary, cap/ves manager and best employee benefits consul/ng firm by mul/ple industry sources. Visit www.aon.com for more informa/on on Aon and www.aon.com/
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