Understanding Employee Stock Purchase Plans and How They Operate

Written By:
Surabhi
Calendar
June 26, 2024

In the extremely competitive startup ecosystem, securing the best talent is essential for driving growth. As many startups operate with limited funds, they turn to innovative strategies to compete with established companies. One such strategy is offering equity compensation, such as Employee Stock Purchase Plans (ESPP), to reward qualifying employees with a stake in the company’s future success. 

An ESPP is a program initiated by an enterprise that allows its employees to purchase the company stock at a discounted price. ESPPs create a beneficial scenario for both parties - startups can secure and retain high-quality talent without overextending their financial resources, while employees gain the chance to participate in the company’s success.

With this blog, we will explore the essential aspects of Employee Stock Purchase Plans, including their types, working, benefits, tax implications, and others. 

What is an Employee Stock Purchase Plan (ESPP)?

An Employee Stock Purchase Plan (ESPP) is a program that allows employees to become shareholders by purchasing the company’s stock, usually at a price lower than the market rate.

Employees can participate in the plan by opting for payroll deductions. These deductions accumulate during the period between the offering date and the purchase date. Then, on the purchase date, the company uses these accumulated funds to buy stocks on behalf of the participating employees.

Just like a 401(k) plan for retirement savings, an ESPP is offered as an employment benefit. The primary goal is to enable employees to buy the company’s valuable stock at a lower price, setting the stage for potential profits. As the company grows and becomes successful, the stock’s value increases, enhancing the benefits for the employees.

The discount rate on company shares under an ESPP can vary, but it can go up to 15% lower than the market price. Some ESPPs also feature a ‘look back’ provision that allows the plan to consider a previous stock price. This could be the price on the offering date or the purchase date. As a result, employees can buy the stock at an even lower cost, making the plan more beneficial for them.

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Important Dates

Here are the important ESPP dates that you, as a startup founder, need to be aware of:

  • Offering Date: This is the date when the ESPP is officially launched. It marks the beginning of the offering period, during which employees can enroll in the plan.
  • Enrollment Date: This is the deadline by which employees must decide whether or not to participate in the ESPP. By this date, employees need to commit a certain percentage of their salary to the purchase of company stock. Employees need to understand that once they enroll for ESPP and the purchase period begins, they typically cannot change their payroll deduction amount until the next offering period.
  • Purchase Date: This refers to the date when the company utilizes the collected payroll deductions to purchase company stock for the employees participating in the plan. On this day, the employees officially become shareholders in the company.

Eligibility

The eligibility criteria for ESPPs can vary across companies, but there are some common factors that determine whether an employee can participate in an ESPP:

  • Employment Status: Full-time employees are usually eligible to participate in an ESPP. Part-time employees, contractors, or temporary workers may not be eligible, depending on the company’s specific plan rules.
  • Tenure: Some companies require employees to have a certain length of service before they can participate in the ESPP. This tenure requirement helps ensure that the benefits of the ESPP are offered to committed employees who have demonstrated their loyalty to the company.
  • Job Position: In some cases, the eligibility to participate in an ESPP may be tied to the employee’s job position. Senior-level employees, for instance, might have access to the ESPP, while entry-level employees might not.

You can impose certain restrictions on eligibility to maximize benefits from ESPPs. For example, an employee might need to maintain a certain level of performance for a given duration, or your company may limit the number of shares an employee can purchase.

ESPP Deductions

When an employee decides to participate in an ESPP, they choose a percentage of their salary to be deducted from each paycheck. This percentage ranges between 1% and 15%, but the precise value can differ based on your company’s rules for such plans.

During the offering period, the deductions are accumulated. Once this period concludes on the purchase date, these collected funds are used to acquire company shares for the employees participating in the plan. The shares are bought at a price lower than the market rate, offering a potential financial advantage to the employees.

Understanding these deductions is crucial for your employees, as participating in an ESPP means committing a portion of their monthly salary for a considerable duration. Hence, employees must consider their personal goals to decide how much they can contribute to the plan.

How Do ESPPs Work?

Here is a step-by-step explanation of how ESPPs function:

  • Step 1: Enrollment: The process begins with enrollment of plan participants. Eligible employees decide whether they want to participate in the ESPP and specify a percentage of their salary for payroll deductions.
  • Step 2: Offering Date: This is the day when the payroll deductions start.
  • Step 3: Offering Period: The offering period is the extended timeframe during which employees can elect to participate in the ESPP. The length of the offering period can vary between 12 to 27 months.
  • Step 4: Payroll Deductions: During the offering period, the specified percentage of the employee’s salary is deducted each pay period. These deductions are accumulated without any interest.
  • Step 5: Purchase Period: It is a subset of the offering period and occurs every six months. On the purchase date, the company uses the accumulated payroll deductions to purchase company stock on behalf of the participating employees.
  • Step 6: Purchase of Shares: The shares are purchased at a discount price, often up to 15% lower than the market price.

Let’s illustrate this process with an example. As a founder, you offer an ESPP for an important employee. The employee decides to enroll in the plan and starts contributing 10% of the salary. Over the six-month offering period, these deductions accumulate, and at the end of the offering period, you use these funds to purchase shares on the employee’s behalf. The shares have been bought at a 15% discount from the market price, giving the employee an immediate return on their investment.

Employee Stock Purchase Plan vs Stock Options

ESPPs and stock options may seem similar, but they are fundamentally different in how they work and in terms of benefits and tax implications.

 Comparing ESPPs and Stock Options

What are the Different Types of ESPPs?

Employee Stock Purchase Plans (ESPPs) can be broadly categorized into two types: Qualified ESPPs and Non-Qualified ESPPs. Here are important details related to both these options:

Qualified ESPPs

Qualified ESPPs are the most popular type of plan, and they must comply with certain criteria established by the Internal Revenue Service (IRS). For example, before they can be put into action, qualified plans must receive approval through a shareholder vote, and all participants in the plan have equal privileges. The duration of these plans’ offering periods cannot go beyond 27 months, and the discount on the stock price is capped at 15%.

One of the key advantages of qualified ESPPs is the tax benefits they offer to employees. The discount received on the purchase of company stock is not taxable until the stock is sold. Any additional gain may be subject to capital gains tax.

Non-Qualified ESPPs

On the other hand, Non-Qualified ESPPs do not meet the IRS criteria and offer higher flexibility in how a non-qualified plan can be designed. For example, they may offer a discount of more than 15% from the current Fair Market Value (FMV) of the stock.

However, non-qualified plans do not offer the same tax advantages as qualified plans. The discount received on the stock at purchase is taxed as ordinary income, whether or not the employee sells the stock in that calendar year.

Advantages and Disadvantages of ESPPs

ESPPs offer a range of benefits for both employees and employers. However, like any financial instrument, they also come with certain challenges. 

Benefits of ESPPs

For Employees

  • Discounted Stock Purchases: One of the most attractive features of ESPPs is the ability to purchase company stock at a discount, typically ranging from 5% to 15%. This immediate discount provides a built-in profit at the time of purchase, even before any potential stock price appreciation.
  • Potential Financial Gains: If the company’s stock price rises, employees stand to make a substantial profit when they sell their shares. This potential for financial gain is over and above the initial discount on the stock purchase.
  • Increased Engagement: Owning company stock can foster a sense of ownership and engagement among employees. Their interests align with the company’s success, motivating them to contribute to the company’s growth and profitability.
  • Automatic Payroll Deductions: ESPPs operate through automatic payroll deductions, making it convenient for employees to invest in company stock. This eliminates the need for employees to manage separate transactions, making the investment process seamless and hassle-free.
  • Tax Advantages (for Qualified ESPPs): Qualified ESPPs offer potential tax benefits. The discount availed at the time of stock purchase is not taxable until the stock is sold. If the shares are held for a certain period, any additional profit may be taxed at the lower long-term capital gains rate.

For Employers

  • Enhanced Employee Loyalty: Offering ESPPs can significantly boost employee loyalty and retention. When employees own a piece of the company they work for, they are more likely to stay with the company and contribute to its success.
  • Competitive Compensation Package: ESPPs can enhance the overall compensation package, making your company more attractive to potential hires. In competitive job markets, offering unique benefits like ESPPs can set your company apart and help attract top talent.
  • Alignment of Interests: When employees own stock, they directly benefit from the company’s success. This alignment of interests can promote a unified effort towards achieving common goals and driving company growth.
  • Employee Satisfaction: Offering ESPPs can increase overall job satisfaction and morale. Employees who have the opportunity to share in the company’s financial success often feel more valued and appreciated. T

Challenges of ESPPs

For Employees

  • Financial Risks: If the company’s stock price falls, employees could face financial losses on their purchased shares. Employees need to diversify their investment portfolio and not rely solely on their company’s stock.
  • Complexity of Management: Managing ESPP investments can be complex. Employees need to track purchase dates holding periods, and understand the tax implications of their investments. This requires a certain level of financial literacy.
  • Lock-Up Periods: Some ESPPs may have lock-up periods that prevent employees from selling their shares immediately after purchase. As a result, the liquidity of the investment is restricted.
  • Concentration Risk: There is a risk of having too much personal wealth tied up in a single stock, especially if it’s also tied to employment. If the company faces financial difficulties, employees could lose both their jobs and a significant portion of their investment.

For Employers

  • Administrative Burden: Managing an ESPP involves dealing with enrollment, payroll deductions, stock purchases, and compliance with regulatory requirements. This can lead to a considerable administrative burden on your company.
  • Costs: Offering an ESPP can involve financial costs, such as the cost of the discount on the stock price and potential accounting expenses related to managing the plan.
  • Communication Challenges: Effectively communicating the details and benefits of the ESPP to employees is crucial. You need to ensure that employees understand how the plan works, its potential benefits, and its risks.
  • Regulatory Compliance: ESPPs are subject to regulations, and strict adherence to these regulations will require you to commit significant resources.

What are the Tax Implications of Participating in an ESPP?

As an employer offering ESPPs, it’s important to understand that the tax treatment for ESPPs varies depending on whether they are qualified or non-qualified and on how long the employees hold the shares before selling. 

Tax Treatment for Qualified ESPPs

In this case, employees typically do not incur taxes when they acquire the stock. Taxes come into play when they decide to sell, trade, or transfer their shares. The tax treatment depends on how long employees hold their shares:

  • Qualifying Disposition: If employees hold their shares for at least one year after the purchase date and two years after the offering date, they will incur ordinary income tax on the lesser of the two: some text
    • The discount received on the purchase price or 
    • The actual gain

Any additional profit between the purchase price and the sale price is subject to long-term capital gains tax.

  • Disqualifying Disposition: If employees decide to sell their shares before the specified holding period, they are required to pay ordinary income tax. This tax liability is calculated as the difference between the market value of the shares at the time of purchase and the actual purchase price. Any extra profit made is subjected to capital gains tax, which typically has a lower tax rate.
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Tax Treatment for Non-Qualified ESPPs

Non-qualified ESPPs do not provide the same tax benefits. The discount received on the purchase of company stock, which is the difference between the market value and the purchase price, is treated as taxable income in the year of purchase. Any further profit made at the time of sale will be regarded as a capital gain and is taxed as such.

Conclusion

Understanding Employee Stock Purchase Plans (ESPPs) is crucial for you as a startup founder to make informed financial decisions and attract the best talent in the industry. However, managing ESPPs and other equity-related matters can be a complex task, and to streamline this process, you must partner with Qapita.

At Qapita, we are market leaders in automating workflows around equity processes for CapTables, ESOPs, Due Diligence, and Transactions. With in-house experts possessing multiple years of experience in equity management, Qapita offers a one-stop solution for all your equity management needs.

We have recently achieved an incredible milestone and have been named the #1 Equity Management Software Platform by customers on G2. This recognition is a testament to the remarkable satisfaction ratings their customers have given Qapita across all aspects of our platform and services.

Get in touch with our experts, and let’s explore how we can help streamline your equity matters.

Surabhi

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