ESPP vs ESOP: Differences Between Equity Linked Compensation Structures

Employee stock purchase plan (ESPP) and employee stock options plan (ESOP) are two common methods used by startups and large enterprises to reward and retain employees.

Both employee stock purchase plan and employee stock options plan give opportunities to employees to secure shares in their company and benefit as the company grows.

In this post, we’ll discuss:

• What are ESPP and ESOP
• Their pros and cons
• The key differences between ESOPs and ESPP

Let’s start with the employee stock purchase plan first.

Employee Stock Purchase Plan (ESPP)

ESPP is an employee benefit program under which employees get the company's share at a discounted price. It's the choice of employees whether they want to participate in the ESPP program of the company or not.

ESPP programs are mostly seen in public companies. The participating employees contribute a part of their salary, usually between 1% to 15%, every month for a specified period. The accumulated amount is used to purchase shares for the employee at a discounted price at certain intervals.

The discount percent depends on the plan terms and is mentioned in the ESPP policy of the company. The purchase price is taken as the share price on the purchase date with the discount.

When the employee selects the percentage of salary to be deducted for the ESPP program, the offering period begins. The period can last anywhere from 6 to 27 months.

The accumulated funds are used to purchase the shares of the company at a discounted price. This is the **Purchasing Date. **

If there is a lookback provision in the ESPP policy, the discount is taken on the lower of the share price as on the offering and the purchasing date.

Some companies allow a flexible policy to opt out of the program in the middle of the offering period.

Example: How does ESPP Work?

Let's go through an example to understand how ESPP works.

Let's say a listed company offers an ESPP program to its employees. According to the plan, the discount is 10% and the offering and purchase periods are both 6 months. There is a lookback provision in the policy too. An employee Abhishek, whose salary is Rs 90,000 enrolls in the company's ESPP program for 6 months. He chooses to go for a 15% deduction from this salary towards the ESPP program. Amount deducted per month = Rs 13,500 Amount accumulated in 6 months = Rs 81,000

Case 1: When the share price increases.

Say, the share price on the offering date is Rs 90 and Rs 120 at the end of 6 months. The Shares will be purchased for Abhishek at the end of 6th month.

The share purchase price is determined as follows:

• Lower of the share price as on offering vs purchase date = Rs 90
• Discount per share, 10% = Rs 9
• Purchase price per share= 90 - 9 = Rs 81

The total shares purchased = Rs 81,000/Rs 81 = 1000

Case 2: When the share price decreases.

Now, suppose, the share price on the offering date is Rs 90 and Rs 60 at the end of 6 months. The Shares will be purchased for Abhishek at the end of the 6th month.

The purchase price is determined as follows:

• Lower of the share price as on offering vs purchase date = Rs 60
• Discount per share, 10% = Rs 6
• Purchase price per share = 60 - 6 = Rs 54

So, the total shares purchased = Rs 81,000/Rs 54 = 1500

In the US, the ESPP program is of two types: qualified and non-qualified. The qualified ESPP programs have better tax benefits than non-qualified ESPP programs but are subject to restrictions on maximum discounts allowed.

Now, let’s see the pros and cons of the employee stock purchase plan.

Pros of Employee Stock Purchase Plan (ESPP)

• Increases employee morale and retention.
• Helps in aligning the shareholders and employees interests for the growth of the company.
• It may allow flexibility to withdraw during the participation period.
• The lookback feature in the ESPP scheme helps employees to purchase the shares at a lower price.

Cons of Employee Stock Purchase Plan (ESPP)

• It's subject to share price volatility. If the share price decreases, it can be a loss for the employees.
• Increases the administrative, accounting and HR workload.
• Employees won't participate if they don't believe that the share price will go up in the future.

Employee Stock Options Plan

Now, let’s discuss the employee stock options plan and what are its pros and cons.

ESOP stands for employee stock options plan and gives employees the right to purchase the company's shares at a certain price known as the strike price as per the ESOP scheme. The employees may choose to purchase the stocks once the options vest.

Before creating the ESOP scheme, you may want to familiarize yourself with terms related to ESOP

ESOPs are common in startups and a good way for founders to give competitive compensation to their employees.

Recently, many employees saw substantial wealth creation during the ESOP buybacks by companies

Pros of Employee Stock Options Plan

• Aligns employees' interests with the shareholders.
• Compensate for lower salaries for acquiring good candidates, when startups have limited cash.
• Motivates employees to create value and helps in retention.

Cons of Employee Stock Options Plan

• Dilutes ownership of the founders, as the company has to create a dedicated option pool for the employees.
• Employees have to pay an exercise price.
• Employees have to pay taxes twice, first at the time of exercising and then at the time of selling.
• For unlisted companies, there could be tax implications in the hands of employees upon exercise.

ESOPs come with complex rules and regulations and require companies to maintain accurate records. Qapita, an equity management tool, makes it easy to grant and administer ESOPs.

Difference Between ESOP and ESPP

Let’s look at the differences between these two. The most evident difference is that ESOPs are quite common in startups while ESPP exists in public companies.

How Qapita can Help you in ESOP Administration

Qapita is an equity and ESOP management platform. It digitises your ESOP management completely from creating an ESOP scheme to granting stock options till they convert to shares or lapse. Since it eliminates the paperwork, there are minimal errors, and it's free to 25 stakeholders. Qapita also enables you to communicate the value of ESOPs to your employees.

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