Fundamentals Of Employee Stock Purchase Plans (Part 1): Basic Structure And Terms
Your company's employee stock purchase plan (ESPP) may be one of the best employee benefits in your total compensation package. However, to maximize the value of your ESPP, you need to understand how this type of plan works.
This four-part series on ESPP fundamentals discusses basic design elements, typical plan procedures, and taxes. In Part 1, we focus on basic plan structure and on technical terms used to describe your ESPP, and we present an example of how ESPPs work in both up and down markets.
What Is An ESPP?
At its simplest, an ESPP is a special form of employee stock plan that operates like a subscription purchase plan but is treated for tax purposes like a stock option plan. ESPPs come in a variety of "flavors," including both tax-qualified plans (Section 423 plans) and nonqualified plans. However, typically all types of ESPPs are designed to allow regular, ongoing purchases of your employer's stock through accumulated post-tax payroll deductions, frequently at a discount from the stock market price ("market value" for our purposes) on the date of purchase. Generally, all purchases under an ESPP take place on a set date at a formula price based upon market factors.
Key ESPP Terms
One easy way to understand plan structure is to master some of the terms that designers use to describe ESPPs. Once you understand the terms, you can apply them to the examples in this series.
- Option: Your right to participate in an offering period. The term of the option is the term of the offering period.
- Offering Period: A period during which your rights to purchase stock under the ESPP are outstanding. The offering period begins for all participants on the offering date and ends on a pre-determined purchase date. Your ESPP may feature Overlapping Offering Periods, in which several offering periods run concurrently but have different offering dates (and, accordingly, may have different purchase prices), or Consecutive Offering Periods, in which a new offering period begins on the day after the old offering period ends.
- Offering (or Enrollment) Date: The first day of the offering period. Same as "date of grant" for tax purposes.
- Purchase (or Exercise) Period: Period during the offering period that is shorter than the offering period. There is always a purchase date at the end of a purchase period. Although the first day of a purchase period may not be the offering date (e.g., a 12- or 24-month offering period may comprise a series of six-month purchase periods), the use of the term "purchase period" generally means that the purchase price will be determined with reference to the offering date rather than with reference to the first day of the purchase period.
- Purchase (or Exercise) Date: Pre-determined date upon which stock is bought for all participants during or at the end of an offering period. There is always a purchase date at the end of the offering period. If there are several purchase periods during a single long offering period, there will also be several purchase dates (one at the end of each purchase period). For example, a 12-month offering period that includes two purchase periods will have a purchase date at the end of every six months.
- Purchase (or Exercise) Price: The purchase price of a share of stock bought at the end of a purchase period or offering period. If the ESPP includes a "lookback provision," the purchase price will be determined by comparing the market price of a share of stock on the offering date with the market price of a share of stock on the purchase date, and applying a discount (up to 15%) to the lower of the two prices.
- Automatic Low Offering Period: An offering period that automatically terminates on any purchase date on which the price of a share of stock is lower than the price of a share of stock was on the offering date. This ensures that the offering date price is always the lowest price for comparison when a lookback provision is used to set the purchase price.
A big advantage of a Section 423 plan is that the tax code permits a discounted purchase price to be computed using a "lookback provision" while still allowing options granted under the plan to be eligible for special tax treatment (discussed in Part 3 of this series). When the plan uses a lookback provision to determine the purchase price, it is computed on as much as 85% of the market price on either the offering date or the purchase date, whichever price is lower. (Check your plan for the details, as discounts and lookbacks are frequently changing.)
The purchase price is calculated on the purchase date, and then the purchase is made for you automatically. The number of shares purchased for you is determined by dividing the amount of money credited to your account for that period by the purchase price (subject to any share or dollar cap amount imposed by the plan or the tax code, as explained in Part 2).
Employers are not required to include a lookback provision in an ESPP. In fact, no requirement makes an ESPP give the full 15% discount or any discount at all. With mandatory ESPP expensing, companies are making many changes in their ESPPs, as a related FAQ explains. The simplest form of ESPP may be no more than a regular "open market" purchase plan that automatically buys stock at the current market price.
Offering Period Structure
Another design element that is determined by your employer is the length of the offering period under the plan. Employers may choose either a short or a long offering period. A short one has a single purchase date, after which the offering period ends and a new one (with a new offering date price) begins. A lengthy offering period might last as long as two years and include many purchase periods. Because each offering period has only one offering date, employers who establish long offering periods generally design them to overlap on an ongoing basis so that new employees may participate in the ESPP even if they join while a long offering period is in progress.
Up-Market And Down-Market Scenarios
Now let's use our knowledge of basic structural terms and elements in examples.
Obviously, in an up market the lookback discount from market value at the offering date can increase dramatically with the stock price of the shares. But by working through the numbers, we can see that even in a down market the discount remains significant.
The market price of the stock is $20 at the offering date of a 12-month offering period. On the final purchase date of the offering period (the last day of month 12), the market price of the stock is $40. The purchase price is computed as 85% of the market price on either the offering date (0.85 x $20 = $17) or the purchase date (0.85 x $40 = $34), whichever is lower. With a $17 purchase price, the actual discount from market price on the purchase date is 42.5% ($17 divided by $40).
The market price of the stock is $20 at the offering date of a 12-month offering period. On the final purchase date of the offering period (the last day of month 12), the market price of the stock is $10. The purchase price is computed as 85% of the market price on either the offering date (0.85 x $20 = $17) or the purchase date (0.85 x $10 = $8.50), whichever is lower. With an $8.50 purchase price, the actual discount from FMV on the purchase date is still 15% ($8.50 divided by $10).
In Part 2 of our series, we'll examine some advanced design concepts for ESPPs.
Alisa Baker is a lawyer in California (at Levine & Baker in San Francisco) who specializes in counseling companies and individuals on executive compensation and employee benefits. She is on the Advisory Board of myStockOptions.com. Among other books, she recently co-authored The Law Of Equity Compensation (2006), published by the National Center for Employee Ownership. Portions of material in this article are adapted from her volume The Stock Options Book (also published by the NCEO). myStockOptions.com selected this article solely for its content and quality. Neither the author nor her firm compensated us in exchange for our publication of this article.