ESPP: What’s In It for the Company?

After reading my post about ESPP, a reader David sent me an e-mail and asked

I’ve read a bunch of stuff about ESPP and while everyone talks about what a good deal it is for the employees who are able to participate, or the tax consequences of the various ways to sell the shares, no one talks about what is in it for the company offering the plan. Any ideas?

My colleagues and I find it hard to believe that our company would offer this without some significant benefit accruing to the company. The $25k limit makes it a drop in the bucket for the bigwigs. So perhaps there is some larger corporate tax savings?

I like this line of thinking. There are always two sides to a coin. Many times the issue becomes very clear when you consider the other side. I do that a lot, like who pays for credit card rewards, whether investing in payday loan companies is a good idea, and what’s going on with the mail-in rebate prepaid debit card.

Back to the question David asked. There are two main reasons companies set up ESPP plans. Before 2005, companies were not required to book an expense for stock options and ESPP. ESPP and, to a larger degree, employee stock options, were cost effective ways to compensate employees. Companies compete for talents. They can pay their employees either in additional cash or via ESPP and stock options. Back then a company didn’t have to book an expense when they let employees buy stocks at a discount as long as their ESPP plan met the requirement of section 423 of the tax laws. Employees got a profit at no cost to the company. If the company paid the employees the equivalent amount in cash, they would’ve had to book an expense and negatively impact their earnings.

Companies do get a tax deduction when employees sell the shares and realize wage income, but they would get the tax deduction anyway had they simply paid more cash to the employees. So tax deduction was not the reason companies set up ESPP programs. Not having to book an expense was.

ESPP plans also create employee loyalty. When employees own stocks in the company (if they didn’t sell right away), they are more likely to work harder. In management buzz words, the employees’ interests are “aligned” with the company. Although employees are allowed to sell right away, many don’t because of the endowment effect — if you give them cash they won’t buy the stock but if you give them stock they won’t sell it for cash — or because they wanted to gamble for the favorable tax treatment.

The accounting rules changed in December 2004 when the Financial Accounting Standard Board (FASB) issued FAS 123(R). Now companies are required to book an expense for their ESPP unless the discount is no more than 5% and the program doesn’t have a look-back[1] provision. As a result, many companies discontinued or scaled back their ESPP plans. Many of them reduced the discount from 15% to 5% and removed the favorable look-back provision in order to comply with FAS 123(R) and keep the ESPP off their income statement.

For competitive reasons, some companies chose to keep their program as-is at an increased cost. Count yourself lucky if your company still offers the 15% discount with a look-back feature. A 5% discount to the purchase price at the end of the period reduces the annualized return from about 90% to about 20%. It’s still profitable, but it’s not nearly as nice.

 [1] The look-back provision allows the employees to buy stocks at a discount to the stock price at the beginning date or the price at the end date, whichever is lower.