ESPP Programs – Compensatory vs. Non-Compensatory

 

By Denise Scoville-Glackin and Kathy Biddle. Employee stock purchase plans (ESPPs) provide an effective way to incentivize employees and offer lower compensation cost and tax advantages to the issuer. When developing an ESPP plan, companies must consider a number of regulatory requirements which may affect the cost of the program and participation rates. Under the current U.S accounting rules (Financial Accounting Standard Certification Topic 718), companies must expense the fair value of their employee ESPP unless the plan meets the defined safe harbor requirements. To comply with the safe harbor policy, a company must limit any ESPP purchase price discount to no more than 5% and prohibit option-like features, such as lookback periods, to be considered non-compensatory.

Some companies have found thisQuestion Mark approach lacks appeal for employees. To keep up with the competitive hiring market, a company may forgo the safe harbor provision and offer an ESPP with a lookback and a discount of 15%. In fact, according to the NASPP 2014 Stock Plan Administration Survey, 66% of companies with a Section 423 plan offer some type of lookback. And the majority of companies offer more than a 5% discount, which qualifies an ESPP as compensatory and requires expense.

Compensatory ESPPs are valued using the same methods as stock options, and the valuation methodology is used to create the fair value for each share of the grant. For ESPP, the key inputs that drive the fair value are expected term and volatility. Another key driver is the discount given at the time of grant.

Expense (fair value) is then comprised of three components:

  • value of any discount
  • value of the call option (if lookback feature is included)
  • value of put option (if no limit on shares purchased if the price declines)

To curb the expense related to ESPP, you can implement share limits as a plan feature where participants can purchase only up to a certain number of shares over a given period. According to the NASPP survey, 56% of companies have a limit on shares purchased. In addition, the IRS has a statutory dollar limit in place indicating that Section 423 plan participants can’t purchase more than $25,000 worth of stock in a calendar year.

When designing an ESPP plan, there are a few things you may want to contemplate. If you are concerned with the cost, you may want to eliminate a lookback feature and shorten the offering periods to reduce the compensation expense. In addition, you can set a limit on the number of shares purchased. To avoid the challenges of modification accounting, you should also consider eliminating contribution changes mid-cycle and including reset provision to avoid modifications.

If you are still hesitating about implementing an ESPP, read our blog, 5 Reasons Your Company Should Consider an ESPP, to find out what this program can bring to your company. If your company already offers an ESPP, learn more about how Certent can help make it easier.

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