Employee Stock Option Plan (ESOP) vs Employee Stock Purchase Plan (ESPP)
Employee stock purchase plans (ESPP) and employee stock ownership plans (ESOP) are two of the most popular kinds of employee benefit options.
Employee stock purchase plans (ESPP) and employee stock ownership plans (ESOP) are two of the most popular kinds of employee benefit options. And by being a business owner, you can promote any of these employee stock plans in your company to motivate your employees.
To begin with, an ESOP is something that most entrepreneurs are familiar with as they are very popular. It is a benefit plan that permits the company to set up a trust fund. Once this has been done, the tax-deductible contributions of new shares of its own stock can be distributed to purchase existing shares, create a market for closely-held shares of a departing shareholder, or converted into cash. But the main idea behind ESOPs is to reward employees by offering them access to a piece of company ownership.
On the other hand, an ESPP is an employee stock purchase program. This kind of program exists in publicly-traded companies where an employee can contribute a percentage of their pay every month towards the purchase of the stock of the company. The moment a predetermined interval takes place, typically happening every 6 months, then the balance saved by the employee is utilized to purchase the company’s shares at a discounted rate.
What is an ESOP or Employee Stock Ownership Plan?
As mentioned before, an ESOP is an employee benefit plan which offers workers an ownership interest in the company. ESOPs offer the selling shareholder, the sponsoring company and the participants with several tax benefits. This is also a reason why this is a highly qualified plan for any private company. Additionally, companies frequently use ESOPs as a corporate-finance strategy, and to align the interests of their employees with the shareholders in the company.
Since ESOP shares are a part of the remuneration package of employees, companies can easily use ESOPs to keep staff participating in the plan focused on the share price appreciation and corporate performance. By offering the plan participants an interest in seeing the stock of the company perform well, these plans encourage them to do what is best for the shareholders of the company (since they too are the shareholders of the company through this plan).
And when the stocks vest completely and the employee leaves the company, the company “repurchases” the vested shares back from the employee. The money gained from the purchase goes to the employee in a lump sum or equal periodic payments, based on the rules of the plan. As soon as the company gets back the shares, they redistribute or void the shares.
Employees that retire or resign from the company are not allowed to take the shares with them. All they can take with them is receive the cash payment when the company repurchases the shares. On the other hand, employees who have been let go only receive the amount they have vested in the plan.
There are some companies where a majority of the holdings are held by the employees. Such companies are called employee-owned corporations. But in such a company, the capital is not distributed equally. A lot of these companies offer only voting rights to some particular shareholders. Additionally, some companies can also offer senior employees the benefit of more shares as compared to new employees.
Pros & Cons of ESOPs
Let us understand more about ESOPs by looking into its pros and cons.
Pros of an ESOP
There are a lot of reasons why you should incorporate an ESOP plan in your business. Below are the reasons why:
- Offers internal control over each transaction: If you are in doubt about the continuation of the business over the long-term, an ESOP is the best tool to use. A lot of entrepreneurs work hard to establish a brand in the market. And if the stock is issued in a general way, they might lose some control of the company. With an ESOP, the company owner can easily raise funds for themselves without the fear of losing control and in a faster period of time.
- Offers a morale boost to the organization: The employees who are a part of the ESOP usually find value in the vesting opportunities offered. And they work towards growing the company. When the company grows, so does the wealth of the employee. It acts as an incentive to help them in boosting their morale and working harder. This eventually leads to a higher level of overall success in the company.
- Becomes a gradual transition: An ESOP does not force the owners into making a fast decision to liquidate their assets in the company. They can decide to sell partial ownership through an ESOP by keeping a majority control over the company. In case a minority stake is issued via an ESOP, the ownership is still allowed to sell the company to third parties in the future.
- Offers tax advantages: There are obviously a lot of tax advantages that come with an ESOP. You can deduct the principal amount of the ESOP from your taxes. A few shareholders in the company can even elect to enjoy the benefit of Section 1042 deferrals to momentarily delay the capital gains linked to their sales. And if your company is an S corporation, the share of recognized earnings from an ESOP is usually exempt from income taxes.
- Creates liquid capital: A lot of business owners have their assets tied up in their company, which makes it tough for them to access it from a cash standpoint. With the help of an ESOP, the owners can easily bring the process of converting their closely-held shares into capital, which is more liquid and diversified.
Cons of an ESOP
Nothing is perfect in this world, and the same holds true for ESOPs. This means that, even though ESOPs have a lot of benefits, there are some drawbacks as well. These include:
- Difficult to maximize the proceeds of an ESOP: When an ESOP plan comes into place, the current shareholders in the company would not be able to maximize their proceeds. The main reason behind this is that the average ESOP buyer is financially, but not strategically motivated. The ESOP can pay up to the FMV of the share and nothing more. Strategic buyers have the ability to pay more as the search to recoup the difference with future growth opportunities.
- A lot of ongoing costs exist: Just like every other stock management plan, an ESOP too would have many ongoing administrative costs that have to be paid. You will need to spend money on the annual valuation, the legal fees, trustee fees, and administration fees. Due to these unexpected expenses, you need to be smart in making the decision to launch an ESOP for your company.
- 100% ESOP may demotivate potential investors: In case a company decides to sell 100% of the outstanding shares via an ESOP, then the outside lenders become less motivated to offer funding opportunities.
- Might cause regulatory headaches: An ESOP has to follow all the market laws and regulations, tax laws, and current security laws. You will need a proper planned administration for this as the HR department usually oversees these things. If the plan is not compliant with the rules, all the money gained from the employees in the plan would be of no value. And this would cause low employee morale and it would turn out to be a loss for the company.
The cons are basically things that you need to take care of strictly if you want the plan to move smoothly and work well for your company. By taking care of everything properly, you will easily be able to rock the plan and grow your company.
What is an ESPP or Employee Stock Purchase Plan?
An ESPP is a company-run program where the participating employees can buy the company stock at a discounted price. Employees donate to the plan through their payroll deductions that build-up between the purchase date and the offering date. On the day of the purchase, the company utilizes the accumulated funds to buy the stock in the company for the participating employees.
The discount rate on the shares of the ESPP is completely dependent on the plan. But the discount can be as low as 15% from the market price. An ESPP might also have a “look back” provision permitting the plan to utilize a historical closing price of the stock. It can be the price of the stock on the purchase date or the offering date, whichever is lower. But there is more to ESPPs than just this. It has been explained below.
Qualified Vs. Non-qualified Plans
There are two categories of ESPPs, including qualified and non-qualified plans. Qualified plans need the approval of the shareholders in the company before implementation. And all the participants need to have equal rights in the plan. Along with this, the offering period of the ESPP can’t be more than a 3-year period. There are also some restrictions on the maximum price discount allowable.
On the other hand, non-qualified plans are not subjected to many of the restrictions of qualified ESPP plans. Even though this might seem like a better plan, non-qualified plans don’t have the tax advantages of the after-tax deductions that qualified plans have.
ESPPs don’t permit shareholders who already own more than 5% of the company stock to participate in the plan. In addition to this, other restrictions are usually in place to disallow employees who haven’t been employed with the company for a specified duration, usually less than one year. Every other employee usually has the choice, but are not obligated, to participate in the plan.
Pros & Cons of ESPPs
Let us understand more about ESOPs by looking into its advantages and disadvantages.
Pros of an ESPP
There are a lot of reasons why you should incorporate an ESPP plan in your business. Below are the reasons why:
- Huge gains for employees: Employees can easily enjoy huge gains with this program. For instance, let us assume that the stock of the company costs $30 now when the price is set for the ESPP plan. For the next 6 months, the employees save money to buy the shares when they are allowed to purchase them. But at this time, the stock price reaches $60. Of course, you will still pay $30 for the stock. And in case you sell the stock instantly, you will end up doubling the amount that you earned from the saving period. This means that the employee will gain a lot out of the ESPP program which is why it is considered as a “guaranteed bonus”.
- Creates an alignment of interests: A lot of employees do not focus on the mission of the company. All they care about is that their job is done well and they earn a paycheck at the end of the month. By offering an ESPP, the company can shift this vision of the employee towards the long-term future of the company. So, the ESPP changes the perspective of the employee and aligns their interests with the company’s mission.
- Offers a vesting period: Even though there are many ESPP benefits in place, vesting periods are needed to get the complete value of the stock purchase. When a stock provides a good value bump to the income of a worker, you are more likely to retain your top workers to keep pushing forward on growth. During this time, you will also be able to teach a specific level of pride within the workforce that encourages higher levels of productivity.
- Reduces turnover rates: With a perfect ESPP in place, the rates of turnover and churn in the standard employee population will often go down. This is since the workers begin to see their job as a long-term investment and not a short-term gain through paychecks. Additionally, there are also higher levels of commitment and loyalty from within each team as the employees would be passionate about what they do.
Cons of an ESPP
Again, just like there are good points about something, there are some drawbacks to it as well. With this said, here are the cons of an ESPP program:
- No guarantee that the employees will come out ahead: A lot of the ESPP programs offer a discount on the purchase price of the stock or stock options price for the employee. But if the ESPP is set up like a traditional stock option, then there is a chance that the employees might not benefit from the program. This plan would not excite your employees and would fail to incentivize them.
- Might need a holding period: If your company’s ESPP has a holding period before the employee can sell the stock that they purchase, it can turn out to be negative. This is because the total gains that they could get would be limited and they would rather stay away from the plan. So, ensure that this is not the case when preparing your summary plan description (SPD).
- Tax implications to consider: If an employee sells off their ESPP stock purchase instantly after they get it for a profit, they will need to pay the standard income tax on the discount they were offered. And the income tax rate is 15% of the amount, which is a lot. And that is not all. After this, the employee would also have to pay the short-term capital gains on the profits they get from the sale.
- Regulatory issues to consider: Just like every other stock option plan, an ESPP program will have to be compliant with the various rules to run smoothly. This means that you will need an officer who would oversee the program and make sure all the security and tax laws are being followed. If not considered and followed, the company could attract penalties and other issues. And taking care of it would cost you a lot on an ongoing basis.
In the end, if you take care of all the needed rules and follow the things perfectly, these cons would not affect the way you run the ESPP plan in your company. And with this, your company will be able to benefit properly from an ESPP program.
Difference between an ESOP and ESPP
With everything clear about what an ESOP or ESPP is, let us now understand what their differences are. To begin with, ESOPs offer employees stock in the company without the need to purchase the shares. This is especially common in closely held companies. In fact, there are about 11 thousand ESOPs in the US at the moment. These ESOPs are normally created when a retiring owner wants to transfer the ownership to the employees in the company.
On the other hand, an ESPP permits employees to use after-tax wages to purchase the stock in their company, normally at a discounted price. These programs are usually common in publicly held companies. And the reason is that private companies can trigger US Securities and Exchange Commission regulations, due to which they avoid incorporating an ESPP plan in their company.
For instance, employees do not pay to participate in the ESOP. Instead, the company contributes funds to employee accounts within a trust that invests in the stock of the company. The other differences include:
- Tax implications: The money in an ESOP account is not taxed until the employee retires. On the other hand, in an ESPP, employees purchase the stock with their own after-tax dollars and have to pay capital gains taxes when they sell their shares. Additionally, the company can choose to deduct ESOP contributions within certain limits. The business owners can sell their shares and delay the taxes as long as they roll the money into qualified U.S. securities. In case your company is wholly owned by an ESOP and pays taxes as an S corporation, you will benefit from several advantages. This includes no federal and no state income taxes, in most states.
- Access to stock balances: ESPP participants can exercise their options when their company vesting schedules permit them to do so, which is normally after one or two years of service. The participants of an ESOP do not have access to their balances until they retire or leave the company just like 401(k) plans.
- Employer costs: ESOPs cost a lot more to start and administer as compared to ESPPs. It is required by law for private companies to purchase ESOP shares from departing employees, which can be a huge expense for the company. Additionally, private companies that have ESOPs need to pay appraisers to figure out their stock price every year.
In short, ESOP vs ESPP is very different from each other. You will need to choose the plan that best suits your company, it’s goals and the future plan of your company.
How can Eqvista help you?
Regardless of their differences, ESOP vs ESPP have their own benefits and are unique ways to offer employees stock benefits in a company. When an employee is offered ownership in the company, it leads to a higher level of happiness, productivity, and financial security. But as you are about to give out shares in your company, just ensure that you are keeping a record of it. The best way to do so is by using a great cap table application.
Eqvista is an application that allows you to track and manage all the shares in your company. In fact, you can easily create ESOP and ESPP programs in this application with vesting schedules and build your cap table accordingly.