Employee Stock Purchase Plan - ESPP
There are two basic points of rationale to an employee stock purchase plan. One is to reward employees with something other than cash. This compensation system allows the company to save cash for other stuff (materials, expansion, corporate excursions to the Bahamas, etc.). The other rationale runs so as to give employees some skin in the company's future. It makes the company more than just a source of a paycheck...the employee becomes part owner (in a vanishingly small way, but still).
The ESPP is a formal way to make this transaction happen. The plans allow employees to buy stock in the company.
You're thinking, "wait, they buy the stock? So, like, they pay their own money to get it...what kind of deal is that?" Fair enough, but often the company gives its workers a deal. It's common for shares to be offered at a discount to the market rate, meaning the employees are already showing a paper profit when the deal happens. And if the stock goes up, they get to bank that profit as well.
In an ESPP, the money for the stock purchases are deducted in little bits from an employee's paycheck, like contributions to a retirement fund.
Row, row, row, your boat...all in the same direction.
Related or Semi-related Video
Finance: What is a Qualified v Non-Quali...11 Views
Finance Allah shmoop What is a qualified versus nonqualified stock
option plan qualified for favorable long term gains tax treatment
Thank you very much if you have qualified stock options
a incentive stock options or ISOs as they're called around
Silicon Valley And yes those air relatively rare They're generally
on ly given to the very first I'ii single digit
number of employees joining a company Then those employees get
the benefit of being able to buy out their stock
options and having them become fully owned Common shares on
very favorable tax bases The ability to buy them out
not have to pay big taxes at the time you
do is a big benefit and well you'll see why
not just for the meaningful vibe of being able TTO
feel like and actually be a co owner of the
company But because it usually means that the employees investors
will qualify for much cheaper tax rates when they eventually
do sell if the employees does not buy out the
options While there's no difference in tax treatment that is
these options are treated just like the nonqualified non stock
options or en esos got it non stock options Gordon
ISOs Well the number which can be granted within a
companies E stop or Employee Stock Option Plan program are
limited And if a company violates this number by granting
too many qualified stock options well then the company is
taxed heavily as it is viewed by the IRS is
having used quote falsely cheap unquote stock to pay key
employees Catch Aly That's called the cheap stock rule applies
to our issues and some other things as well Well
the granting of these kinds of compensatory stock options can
only be given to employees slash insider's of the company
they have to be granted at a fair market value
strike Price III Whatever the four o nine evaluation calculated
by lawyers and bankers and bean counters said the company
was worth That's the valuation the strike price has to
reflect for the the common stock meaning they get an
appraisal from a bunch of bankers and lawyers And they
tell you what the common stock is worth today And
it's usually in an early stage company worth a whole
lot less than the preferred stock because the company's odds
of going bankrupt are really high at that point So
these type of stock options carry a maximum life of
ten years usually And then there are the ten percent
rules that is for at least ten percent of the
shareholders The exercise price of these options has to be
ten percent greater or more than the fair market value
of the company at the time Well because these options
receive such favorable tax treatment there strike price has to
carry a premium right That's that ten per cent thing
And lastly the maximum cap or value of the stock
options for any individual cannot exceed one hundred grand at
least in today's world as exercised or bought out in
any one year In other words they're designed only for
the very early employees with companies carrying very low valuations
E early start ups Okay so that's qualified stock options
The other end of the world nonqualified stock options Yeah
that's for the rest of us blue collar slobs Well
those options can in fact also be bought out But
upon that transaction employees are taxed as if they are
direct compensation and those taxes are levied as ordinary income
I either very high tax rates So in practice most
employees getting qualified stock options by them out almost immediately
And usually there's a negotiation before that employee has hired
such that their commitment to the company has made clear
by their tacit agreement to buy out their qualified options
and have financial skin in the game For employees with
nonqualified stock options and the buyout usually doesn't happen and
those options are viewed as well Gentle lottery ticket potential
big wins way down the line Should the company do
well that's not always the case Sometimes people buy him
out but the big tax treatment favorability eight there So
you and your roommate both joined Shmoop flicks early You
both received the same grant of one hundred thousand options
at a dollar a share strike price How was this
dollar calculated Well lawyers and bean counters were hired for
small feet to make their own valuation assessment of the
company And when they completed that review they determined that
if the company were sold today it's common shares would
command a dollar each on the open market or eBay
or Rush Watch or Fidelity or wherever the company was
sold That number's called the four o nine evaluation in
the strike price of those options applies to pretty much
all the flavors of options you know qualified or ISOs
and nonqualified stock options Unfortunately because you only majored in
E con your package gave you nonqualified stock options whereas
your roommate was an engineer So she received qualified stock
options Not a big deal of the time You didn't
really even care notice other than the one little thing
which was that your roommate borrowed one hundred thousand dollars
to buy out all of her options at that time
a risky move because of the company had gone bankrupt
or done poorly Well that hundred grand would have been
probably zero fast however because they were ice oes She
did not pay any tax on that exercise so pay
it when she sells them at a long term gain
Right Right So then along comes an Ai po and
the stock rocks in the four years Pass and Shmoop
Flix is conveniently for this example problem Hovering around thirty
one dollars a share it is thirty bucks in the
money and then you both go to sell well Your
roommate pays a twenty five percent ish long term gains
rate tax on the thirty dollars times one hundred thousand
or three million bucks That is she pays seven hundred
fifty grand in taxes to net to point two five
million You however pay fifty percent ordinary income tax on
the three million bucks in gain to net one point
five million And remember she had a hundred grand invested
with the company for four years and it took a
lot more risk than you did So if you're feeling
bad well tough beans you paid a lot of tax
so it's a good problem to have But wow the
little word non on your qualified options A plan cost
you seven hundred fifty thousand dollars of winnings in the
form of taxes Ouch So this sounds like Silicon Valley
magic where everyone gets rich and becomes a millionaire by
the time they finish their bar mitzvah speech Oh so
not the case In fact most startup companies in Silicon
Valley go fully bankrupt So had a tax avoiding Mohr
greedy than fearful employee about out all their options qualified
or not And then the company was sold for two
thirds of the value of its preferred stock investment Will
the common stock would be wiped out worthless and all
the money the employees spent buying out there ISOs would
be gone So the business of betting big on start
ups is not one for the faint of heart but
going in The presumption is that well you've carefully watched
this video and others on shmoop finance and you know
the witch and the warlock dance between risk and reward
makes sense you know make dollars