If you own a business, you already know that one of the most effective retention strategies is to give your employees stock options. If not, I highly suggest getting started with something simple yet effective, like the employee stock purchase plan or ESPP.
An employee stock purchase plan allows employees to buy a company's stock at a discount. The discount is paid for with payroll deductions.
69% of the employers stated that the primary reason for offering an employee stock purchase plan is to attract and retain better employees and align the interests of its employees with those of its shareholders.
Employee stock purchase plan are a type of ESOP (Employee stock option plan). It makes buying stocks accessible for employees, allowing them to build their stock portfolios without incurring high costs.
However, to create an employee stock purchase plan, you must first thoroughly understand what it entails.
So let's get started with the core basics.
What Is An Employee Stock Purchase Plan?
The employee stock purchase plan (ESPP) is a type of employee incentive plan where employees are often offered company shares at a discount to the market price.
It makes stocks more accessible for employees, giving them an opportunity to build their stock portfolios without incurring large costs.
With the ESPP, employees can buy company stock at a discount, with funds deducted from their paycheck on a pre-tax basis.
An employee stock purchase plan has a defined offering period during which compensation deductions are made. It comes with a specified purchase date based on the accumulating deductions.
Employee stock purchase plans are also usually referred to as Section 423 plans.
Types Of Employee Stock Purchase Plan
Generally, employee stock purchase plans are categorized into two types: Qualified and Non-qualified Plans.
Let's get into details about what each of them is.
A qualified ESPP is an employee stock purchase plan that complies with IRS Section 423 regulations.
Under a qualified ESPP, employees can buy the stock at a discount and a discount without tax leverages. If the employees hold it for two years and one year from the purchase date, they can further reduce their tax obligations.
Now, there are two primary tax scenarios in which an employee stock purchase plan is taxed.
- If the employee holds onto the stock for a long time, they'll be taxed as a long-term capital gain when they decide to sell it.
- If the purchase price of the stock is less than 100% of the fair market value on the purchase date. When they decide to sell the stock, they'll be taxed as ordinary income.
A non-qualified employee stock purchase plan does not comply with IRS Section 423. It is also referred to as a "direct purchase" plan.
Under a non-qualified ESPP, a tax is applied to the excess of the purchase price over the fair market value. That means that if your company offers a non-qualified ESPP, employees must pay taxes on this amount even if they don't sell the stock.
It means that you're paying more taxes than you would with a qualified ESPP.
Additional gains or losses from selling the stock are taxed as capital gains or losses.
Qualified ESPPs have a significant advantage over non-qualified ESPPs. In qualified ESPPs, employees do not have to pay taxes on the stock until they cash in or sell it later.
Benefits of Employee Stock Purchase Plan
There are several reasons why companies choose to offer employee stock purchase plans.
National Association of Stock Plan Professionals, US surveyed to find companies' key objectives for offering ESPP. Below are the topmost objectives along with the percentages -
1. Employee Ownership - 74%
Employee stock purchase plans encourage a sense of ownership among the employees. When an employee owns a stake in the company, they feel more committed and invested.
Employees feel more of an ownership stake in the company, which leads to higher productivity and greater loyalty. The company also benefits from a more motivated workforce willing to go that extra mile for their employer.
2. Corporate Culture/Branding - 49%
Employee stock purchase plans are a great way to build company culture and create an identity distinct from other companies. Having an ownership culture is a great way to show your employees you care about them and instil a sense of employee loyalty.
Creating a unique brand for your business is an easy way to stand out from the crowd and embed a positive image.
If the company's value increases, your stock value also grows, and so does the profit.
3. Employee Recruitment - 46%
Offering employee stock purchase plans as one of the major employee benefits is a powerful way to attract new talent.
Stock options make your employees part owners. It provides employees with the opportunity to build wealth by owning a portion of their company's stocks.
Employees have a plethora of benefits to select from when starting a new job. Providing stock options as an employee benefit helps you stand out.
Employee stock purchase plans can help attract new talent and also increase employee productivity.
4. Competitive Advantage - 38%
Employee stock purchase plans help you gain a competitive advantage by rewarding employees with equity and not just salary. They can save money on their taxes and benefit from the appreciation of the company's stock.
Employee stock purchase plan gives them this opportunity by linking their financial health to the employee's finances.
5. Employee Reward - 23%
Employee stock purchase plans are an equity-based reward for employees that becomes part of your total reward package.
ESPPs can be a hugely rewarding and fulfilling experience. It also signals that you believe in the company's success and wants your people to enjoy the profits.
6. Wealth Gain - 21%
Employee stock purchase plans are a way of investing, which means you are building wealth for yourself, your family, and your retirement.
In the United States, the most popular type of ESPP is what's known as a tax-deferred profit-sharing plan. This type of ESPP allows employees to make periodic contributions to the company's stock at a discount from its worth.
7. Employee Retention - 17%
Stock purchase plans are a great tool to find and retain top talent.
Employees who get stock purchase plans often stay with the company longer because they are interested in the company's success.
A stock purchase plan often provides a larger ROI than other employee compensation methods such as salary, bonuses, and commissions. The employee has a vested interest in the company's success and will put more work into it.
5 Crucial Steps in Creating An Employee Stock Purchase Plan
Creating an employee stock option plan takes time and effort, but it can turn costlier if some basic steps are skipped.
When designing your employee stock purchase plan, keep the following points in mind.
1. Determine Your Objectives
Your employees are the backbone of your company. To show them that, you need to develop a philosophy around your stock option plan. A key factor in creating employee stock option plans for your company is determining which options to offer.
It should be a collaborative process between your advisors and founders.
Talk about what you're trying to accomplish with your company, and how you want your employees to feel about the company. This will influence the design of the options you want to offer.
It will also include how to make certain they understand the company's mission and objectives.
2. Decide The Allocation Of Shares
Determine how much of your company you plan to share early on. If you plan to distribute stocks, then 100 shares of stock will be one unit. Stock options are often allocated the same way, but companies may opt to give them differently.
Many companies also offer stock options in addition to cash. Stock option plans should outline how these are allocated.
Also, decide how much of your company you will share with employees based on their years of service.
3. Finalize the Plan
It is crucial to take the time to establish your employee stock purchase plan formally. It will help prevent anything from going awry in the future.
The next step in an employee stock purchase plan is to write it and get it approved by board members.
Suppose your employees live in a state other than where you do business. In that case, you must consult with your lawyer to make sure you follow all state-specific regulations.
4. Prepare the Agreement
If you offer stock options and the schedule and type of options are different from the standard, your board needs to approve them. Once they do, make sure to follow through and execute the agreement. Don't forget to send the final copy of the agreement to your employee.
Be sure to gain the approval of your board, then process and execute the agreement.
5. Maintain The Plan
Creating an equity budget is not always an easy task. As companies grow, their focus often shifts to other areas.
One thing to watch is your hiring plan, which should consider the number of stock options you need to reserve for new employees. Your hiring plan should be based on your next funding event, which will help you determine how many stock options you need to secure.
Companies should also take into account the number of shares allocated to future hires.
You need to be able to offer shares to new employees as they come on board. If there is a shortage anywhere, you'll need to take it up with your board and look at changing your HR budget.
Further Reading: A Quick And Simple Guide To Compensation Planning
An employee stock option plan provides equity, security, and investments by incentivizing employees to own shares in the company, increasing their dedication to its success.
The creation of employee stock purchase plans isn't too hard when you have the right tools. Make sure you cover all your bases by moving through the process step by step.