Appraisal Economics performs appraisals of employee stock purchase plans (ESPPs) for financial reporting, tax compliance, and other purposes. Often, these valuations are required under Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic No. 718, “Compensation – Stock Compensation” (ASC 718).
An ESPP provides the opportunity for employees to purchase shares of the company’s common stock through accumulated after-tax payroll deductions. These plans provide an effective way to incentivize and compensate employees. They also benefit the issuing company by lowering cash compensation costs and providing tax advantages. There are two main categories of ESPPs:
Compensatory Plans – These plans involve an option-like feature, as the purchase price is established based on the lesser of: (i) the stock price on the grant date and (ii) the stock price on the purchase date. These plans may allow the employees to purchase stock at a discount to the publicly traded price—up to 15 percent. The per-unit value of an award is economically analogous to a financial instrument known as a “look-back option,” and can be valued using option pricing models such as Black-Scholes-Merton, binomial or lattice models, or Monte Carlo models depending on the specific terms of the ESPP. These plans provide a tax advantage to the issuer as they are recorded as an expense when the options are granted.
Non-Compensatory Plans – These types of plans are much simpler and do not incorporate look-back features. They are used to diversify the shareholder base as they are open to all employees on an equal basis, and the discount to the publicly traded stock price is limited to 5 percent. Non-compensatory plans generally do not provide a tax advantage to the issuer as they are not reported as an expense, but rather treated like a regular stock sale.
Common Types of Compensatory ESPPs
Type A – employees purchase shares at a discount to the lower of: (i) the grant date stock price and (ii) the exercise date stock price. The maximum number of shares purchased is limited to the cumulative payroll withholdings divided by the grant date share price.
Type B – identical to the Type A plan, except that if the exercise data stock price is lower than the grant date stock price, the employee can purchase as many shares as the cumulative withholding amount permits.
Type C – employees purchase shares at the lower of: (i) the grant date stock price and (ii) the exercise date stock price, on multiple purchase dates within the duration of the plan.
Type D – similar to the Type C plan, but with a reset mechanism. If the stock price is lower than the grant date stock price on any of the multiple exercise dates, the employee is able to purchase stock on future exercise dates at the lower of: (i) the reset stock price, that is, instead of the original grant date stock price and (ii) the exercise date stock price.
Type E – this type of plan is similar to the Type C plan, but includes a rollover feature. If the market price of the stock at the end of any purchase period within the duration of the plan is lower than the stock price at the original grant date, the plan is immediately cancelled after that purchase date and a new plan is established using the then-current stock price as the new base price.
Type F – this type of plan is similar to the Type C plan, except the employee may elect to adjust the amount of the payroll witholdings after each discrete purchase period within the duration of the plan.
Type G – this type of plan has a single purchase period with variable withholdings. The employee may increase or decrease the dollar amount or percentage of salary withheld prior to the exercise date.
Type H – this type of plan combines the features of Type C and Type G plans. There are multiple purchase periods within each plan, and employees may elect to increase or decrease the amount of salary withholdings.
Type I – this type of plan is the same as the Type G plan, except the employee is allowed to make cash infusions after increasing the withholding amount. The effect is that if an employee increases the withholding amount, the employee can contribute catch-up contributions for periods prior to the change in withholding to give the effect of having participated at the higher rate from the beginning of the plan.
Valuation of a Compensatory Plan
The methodology for valuing compensatory plans involves complex synthetic structures and option pricing models such as the Black-Scholes-Merton model. The valuation of a compensatory plan must consider the amount of any discount from the publicly traded stock price, the duration of the ESPP, the volatility of the company’s common stock, whether the number of shares is limited by any variables other than the cumulative payroll withholdings, and other factors.
Appraisal Economics has extensive experience valuing ESPPs for a wide range of companies. Our analysis is fully supported by a detailed narrative report suitable for review by independent auditors, the Securities and Exchange Commission, and the Internal Revenue Service.
Appraisal Economics has an experienced team of highly qualified professionals with decades of valuation experience. We provide a full range of valuation services, including purchase price allocations, solvency opinions, portfolio valuations, and business valuations. To learn more about how our team of experts can meet your stock-based compensation and other valuation needs, please Contact Us.