The lead-up to an initial public offering (IPO) is the ideal time for your company to review and revise its equity compensation regime. There are many reasons why you should look to do so, not least of which being that some compensation plans that work for a privately held company won’t be suitable for one that is publicly traded.
The reverse is also true, in that some equity compensation approaches will be a more logical fit for a public company, with employee stock purchase plans (ESPPs) very much falling into this category. That being so, it should be no surprise to learn that companies seeking to overhaul their equity compensation practices as they navigate the road to going public will often look to introduce an ESPP.
Put simply, an ESPP gives employees the opportunity to purchase shares in the company they work for. Under this plan, an agreed figure is deducted directly from payroll overtime, and after a predetermined period – usually, six months – that money is then used to purchase shares. Many incentives can be and frequently are offered to encourage participation, which we will look at in more detail later.
The pre-IPO period is the ideal time to look to introduce an ESPP, so that a) it is ready to go or already up and running come flotation day, and that b) you can draft a plan that works for you and your employees without having to consult shareholders, which you would be required to do if you left it until after flotation. That said, it wouldn’t be the end of the world if you waited until the post-IPO period, as ESPPs are generally regarded as being shareholder-friendly, so in that sense seeking approval might prove somewhat akin to kicking an open door.
However, it can be put in place pre-IPO, so why wait? Why not take advantage of the relative freedom that being a privately held company gives you… while you still can!
The benefits of an ESPP to a company
The benefits of an ESPP include reduced turnover and greater work effort
With that in mind, the challenge is to put in place an ESPP that will tick two key boxes – for it to be attractive to employees and for it offers benefits to the company in terms of its day-to-day operations.
It is important to note that these two considerations – being attractive to employees and working well for the company – tend to be interconnected. It’s not quite ‘chicken and egg’ territory, but if an ESPP proves popular with employees, then it will most likely yield positive results for the company, and the vice versa also tends to be true – an ESPP that produces measurable benefits for the company will, by implication, also be working well for employees.
We will look at how to ensure an ESPP is attractive to employees momentarily, but first, what are the typical upsides that will accrue to a company that has put in place a plan that sees a decent take-up internally?
Much has been written about the benefits of ESPPs, but a study published in 2019 in the British Journal of Industrial Relations offered fresh support for the claimed upsides of employee ownership from the company perspective. Written by Alex Bryson and Richard B. Freeman, this study reported positive outcomes among ESPP participants on a range of measures:
- Reduced turnover
- Greater work effort
- More hours worked
- Reduced absenteeism
- Less tolerance of colleagues perceived to be slacking
So, the above is what companies can expect to gain from offering an attractive ESPP to employees. But what does the company need to do to ensure that the plan will be sufficiently appealing to achieve a good level of uptake?
Here are some recommendations:
Include a lookback provision
This provision seeks to protect participants from the whims of the market. In theory, the market value of company shares might be much higher by the end of the offer period than at the start. This means that, if locked into paying the higher price, participants would end up with fewer shares than they had anticipated, which might impact negatively on morale.
Also, the uncertainty on this point might make some individuals less likely to sign up in the first place. A lookback clause seeks to address this concern. Under the terms of such a provision, participants are guaranteed that the per-share price will be based upon the lower value; that is if the market value of the shares is €5 on the first day of the offer period and €10 on the last day, then they will pay €5 per share.
This ensures participants will not be disadvantaged in the event of the share price increases over time.
Offer a discount
While the clause whereby the price per share will be calculated using the lower market value figure is an attractive incentive, offering a formal ESPP discount on top of that can further sweeten the deal.
It is not unusual for companies to include this additional perk, with a cap of 15% normally applied.
To see how this would play out, let’s again say company shares were valued at €5 on day one and €10 on the final day of the offer period. On those numbers, plan participants would be entitled to buy shares at the lower price – €5 – and with a further 15% discount, which would see the purchase price reduced to €4.25.
Factor in an evergreen provision: From the company perspective, it is always a good idea to include an evergreen provision when putting an ESPP in place. In this context, “evergreen” refers to a mechanism providing for regular, automatic increases in plan reserves when appropriate, usually at the beginning of each new plan year.
Again, this falls into the category of “if you can do it before going public, why wouldn’t you?” If you don’t, and then find yourself post-IPO wanting to make provision for an increase in reserves, you will require shareholder approval.
When framed in those terms, you can see why it is attractive from the company perspective to insert an evergreen provision prior to going public, but this is about more than convenience. Whether or not you include an evergreen provision in your ESPP – or other plans – will have a direct bearing on aspects of your overall equity strategy. Plans without an evergreen provision will generally need a larger pool of shares at the outset, and this trade-off will have a bearing on design efforts and the size of share requests prior to an IPO.
Take the time to explain what is being proposed and do so clearly
Surveys show that, despite the benefits that accrue from an ESPP, enrolments rates among employees can sometimes be less than spectacular. Why might this be? Assuming the right incentives are in place, it may simply be that employees don’t realise how advantageous an EPSS can be for them. And if they don’t know, it may mean that you didn’t take the time to explain it to them or to do so in clear, jargon-free terms. As with so much else in the business and in life, clear communication can make all the difference in terms of securing your desired outcome.
So, when you first attempt to pitch an ESPP to your employees, make no assumptions around their understanding of what is being proposed. Some may know exactly what an ESPP is, whereas others might never have heard of it before. Spell everything out, state explicitly how it works, and do so using clear, everyday language, in so far as it is possible to do so. If you lapse into jargon and business-ese and start to sound as if you are speaking in bullet points, you will lose at least a portion of your audience.
The benefits of an EPSS to employees are clear. When they are explained clearly, then you will win over the room and generate the desired enthusiasm.
If you want expert advice on how to set up your ESPP, contact Global Shares now. We have an established track record in equity compensation and will be more than happy to help.