I know my options are underwater, but what about my ESPP?

ESPP_-_impact_of_the_financial_crisis_200811f.doc
I know my options are underwater, but what about my ESPP?

21 Nov 2008

Dan Walter
Performensation Consulting
Contact: dwalter@performensation.com


The impacts of the ongoing financial crisis on stock options and restricted stock units are being documented daily. Some compensation consultants are predicting the end of stock options as a compensation tool, while others are touting the use of mega-grants or option exchange programs. The new term “underwater restricted units” has popped up in articles regarding equity compensation. While many stock options and restricted unit programs affect rank-and-file employees, most are focused on management and executives. So far we’ve heard very little about the effect of rapidly dropping stock prices on broad-based employee stock purchase plans, or “ESPPs,” which pose their own set of problems in this environment.

ESPPs typically allow participants to contribute funds from their paychecks for an extended period of time. Those funds are used to purchase shares at a discount. The most typical structure for these plans collects funds from payroll for six months and purchases shares at the end of June and the end of December. Given this common structure, many plans started their current purchase periods on July 1. Between July 1 and November 21, 2008 the markets have dropped on average between 41% and 45%.  Many companies’ stock prices have declined significantly more than that during the past six months. This drop in stock prices has an enormous impact on ESPPs.

Let’s start with the impact of the $25,000 limit required by the IRS. This rule restricts the value of the shares a participant can buy in a calendar year to $25,000, based on the stock’s trading price on the first day of the purchase period—regardless of whether that’s the ultimate purchase price. For example, if a company’s stock price on July 1 was $50 a share (resulting in a purchase price of $42.50 per share), a participant who hadn’t made any other purchases that year could buy a maximum of 500 shares on December 31. Most plans allow for individuals to purchase at a 15% discount from the lower of the stock price on the grant date or the purchase date, thus effectively limiting the amount of contributions that can be collected from an individual in a given year to $21,250. If the stock price increases during the six-month period, this limit ensures that the participant has a strictly limited upside potential. Assume instead that the stock price drops from $50 per share on July 1 to $10 per share on December 31. The individual would still be limited to purchasing 500 shares, but the purchase price would now be 85% of $10, or $8.50 share. At $8.50 a share, a participant contributing just $4,250 could purchase those 500 shares. Any contributions above $4,250 would be refunded to the participant.

This has two major consequences. The first is that the company will be forced to refund cash to significantly more participants than it would if the stock price were rising. The second is that the total number of shares purchased by all participants will be much higher than initially planned. The result of this is a double negative effect. The company will find itself needing cash to provide a refund to its participants and its allocation of shares for the ESPP will be depleted.

The depletion of shares caused by the lower stock price may have another major impact. Many companies may find that they simply do not have enough shares allocated to the plan to cover the potential shares represented by participant contributions.  When there are not enough shares to cover all contributed funds, each participant is delivered a pro rata number of shares that weights their contributions relative to the overall amount contributed by all plan participants. In this way, each participant receives the same relative number of shares from those available for purchase. Unfortunately, the funds that cannot be used to purchase shares must be refunded to the participant, which in addition to creating a cash burden on the company also creates a public relations issue for the plan.

But there’s an even bigger problem that can occur when the shares allocated to the plan reach zero. Many plans are written so that they are canceled or expire when they run out of shares. New allocations of shares must be approved by shareholders in advance of the plan cancellation, so many companies may not have an active ESPP for the first half of 2009 or beyond. To avoid this companies must seek shareholder approval for replenishing the plan before it runs out of shares. For many companies, these plans are the only form of broad-based equity compensation, which can make an ESPP cancellation both a compensation and employee-relations nightmare.

It is essential that companies ESPPs analyze their share allocations, stock prices, and participants’ proximity to the $25,000 limit as soon as possible.  Depending on the potential impact to participants and the plan, each company must determine the best course of action.  For some companies this may mean a communications program explaining the impact to their participants. For other companies this may mean working with their treasury and payroll departments to ensure that there is enough cash on hand to provide refunds and that a process exists to efficiently deliver these refunds.  In the most extreme cases, companies must determine how they will be affected by the cancellation of their plans.

Most of the problems listed above can be avoided through careful plan design, communication, and administration. Plans may include maximum limits on the number of shares that can be purchased by any one individual or by all participants during any single purchase period. In this way a company can ensure that refunds are limited and the potential for running out of shares unexpectedly is very low. Plans can be designed to move to a state of suspension, instead of cancellation, if the allocated shares are depleted. All companies with employee stock purchase plans should review their current plan design and determine if safeguards should be put in place prior to future grant dates.

In conclusion, the dramatic drop in stock prices not only impacts stock options and related executive compensation, but it can severely impact broad based equity compensation in the form of employee stock purchase plans. It is important that every company with an ESPP analyzes its plan and discusses how the consequences of the financial crisis will be handled. If your company is in this situation, you may want to contact an equity compensation expert for advice on how to proceed.

Dan Walter is the President and CEO of Performensation Consulting.  Performensation provides advice and solutions for equity compensation programs, including employee stock purchase plans, stock options, restricted shares and units, and performance-based programs. You can find more information about Performensation at www.performensation.com. Dan can be reached at (917) 734-4649 or, dwalter@performensation.com, or you can view his profile on LinkedIn at www.linkedin.com/in/danwalter.