Stock options for Employees

Understanding Qualified and Non-qualified Employee Stock Purchase Programs

At face value, the importance of collaboration in the success of a business is not hard to sell. Cheesy, preachy, buzzword-filled quotes about teamwork and collective achievements are never far from reach. All it takes is the liberal peppering of newsletters, job descriptions, and websites with these promises of equal profits from growth.

However, words are empty without action. It is for this reason that businesses have increasingly begun to turn towards equity sharing to fulfill these promises. The Employee Stock Purchase Program (ESPP) proves itself to be an ideal solution, given the simplicity and liquidity it offers employees in purchasing company stock.

We explore ESPPs in detail below, specifically concerning qualified and non-qualified schemes, their features, differences, and advantages.

What Are Employee Stock Purchase Programs?

Employee stock purchase programs are important tools in profit sharing. They allow employees to conveniently purchase company stock at a discounted rate through after-tax pay deductions. 

During an enrollment period, employees can choose what part of their salary they would like to contribute towards the plan. These deductions are then collected in a separate account over time, specifically between the offering date (the same as the grant date of the stock option plans) and the purchase date (signals the end of deductions in the period). Once the purchase date has arrived, the amount collected by an employee is then used to purchase stock.

Stock rates are decided by company plans but are usually discounted upto 15%, thereby ensuring that employees can turn a profit. Additionally, some employee stock purchase plans may even offer a ‘look-back’ feature that allows the plan to use a previous closing company share price, increasing potential gains.

ESPPs act as a valuable compensatory tool over and above salary packages, with the hopes to engage employees more deeply in company success, and profits, all while lowering administrative costs.

Additional reading: Avoid These Mistakes While Granting Stock Options

Eligibility Criteria

Since a large part of ESPP’s goals is to attract and retain talent, companies may choose to set some eligibility criteria.

The guidelines typically revolve around two factors: company stock ownership and years of service in the company. Generally, only those employees with less than 5% ownership of stock and those who have been employed in the company for at least a year can be enrolled on the ESPP.

This ensures that sincere employees who are making noteworthy contributions are made a part of the long-term vision and profit targets of the company.

Sequence of Events in an ESPP

Employee Stock Purchase Plans generally happen in the following way:

  1. After considering objectives, share allocations, and eligibility criteria, companies make an offer to eligible employees under the plan.
  2. A cap on the maximum percentage of employee salary that can be contributed is made clear, and employees decide how much they’d like to have deducted from their salaries.
  3. The amount is retained in a separate account by the employer for no longer than 27 months.
  4. On the purchase date, shares are bought at the agreed-upon rate for the employees.

Face-Off: Qualified vs. Non-Qualified ESPPs

The key differences between qualified and non-qualified employee stock purchase programs are related to factors of flexibility and taxation.  

More specifically, qualified ESPPs are much more rigid on the plan’s terms and conditions since they are controlled by governmental regulators. Qualified plans must also be approved by all shareholders before being implemented. However, qualified ESPPs are preferable when it comes to taxation since no taxes are owed on the discount or shares at the time of purchase.

Tax obligations can be further reduced if the stocks are held for two years post grant and one year post purchase. Hence, the stocks fall under the ambit of long-term capital gains if and when they are sold.

On the other hand, non-qualified stock purchase programs are more flexible in the sense that they are not governed by so many regulations and can be formed according to company fancies. Discount rates could be higher than 15% and can even allow share matching from the company’s side. However, employees are taxed upon the purchase of the stock, which tends to discourage employee participation.

More specifically, the difference between the purchase price and fair market value is taxed as normal income, while any gains or losses upon the sale of the stock are taxed as capital gains or losses. While employees may not receive much of a tax break, companies can stand to gain a financial advantage since the cost incurred can be deducted as an operating expense.

Powerful Tools: The Advantages of Employee Stock Purchase Plans

ESPPs tout various benefits, among which the most common are:

1. Attraction

Having a fair ESPP in place creates an ownership culture that is intricately tied to a company’s brand and identity. Companies with a reputation that precedes them have no problems attracting potential talent to fill open positions. An increase in implicit value has a very real impact on tangible factors, i.e., better market standings lead to increasing stock values.

2. Retention & Motivation

Good employee stock option plans provide workers with enough financial incentives, security, and trust in the company trajectory. This automatically makes employees more loyal, dedicated, and motivated to work towards collective success.

The Flip Side: Risks of Employee Stock Purchase Programs 

While employee stock purchase programs are relatively straightforward equity sharing plans, their implementation can be rather complex. Many HR functions and legal, tax, and administrative efforts are required to set up the stock purchase plan.

Furthermore, positive effects on hiring and talent retention depend greatly on company stocks performing well. There is always a risk of prices falling, employees incurring losses, and morale plummeting. If employee participation takes a hit, this can further exacerbate the problem of falling values and motivation.

The Bottom Line

Whatever company motivations may lay behind the desire to have employees on board as stockholders, employee stock purchase plans are a great way to go about it. They’re simple, flexible, and popular.

How you choose to incorporate the thought may vary, but effective equity management must be a part of your plan. trica Equity enters the picture here with the promise of intuitive, single-dashboard management in hand. Book a demo with us today.

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