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:
•
Any plan with an “op/on-‐like feature,” such as a look-‐back period, now results in an expense to the company.
•
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.
2
©2012 Performensa/on
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 (
