Ignoring share limits can increase your compensation expense.
In ESPP Valuation: 4 Missing Pieces, we highlighted several potential reductions to the valuation of an ESPP share under ASC718. In this brief, we will provide more granular detail on share limitations, specifically focused on:
- $25,000 IRS annual purchase limit; and
- Individual share limits as prescribed in the plan document
We will provide more specific detail on when the reduction may become material, and when the limitations should definitively be incorporated into the grant date valuation. In these examples, we will continue with the example from both FASB Technical Bulletin 97-1 and ESPP Valuation: 4 Missing Pieces, in which the fair value of the ESPP plan with a 1-year lookback equals $14.57 based on a share price of $50.00, which is 29.1% of the stock price (based upon a 6-month purchase period, an expected volatility of 30%, a risk-free rate of 2%, and no dividend yield).
Limit #1: $25,000 IRS Purchase Limit
Tax-qualified 423 plans limit participants to purchase no more than $25,000 worth of shares annually, based upon the offering date fair market value. A sharp decline in stock price from the offering date fair market value could cause employees who normally would not hit this limit to be impacted by it.
Chart 1 below illustrates an individual contribution, and the associated probability that the $25,000 limitation will be imposed, and the estimated reduction in accounting fair value under ASC718. For example, an Individual who is contributing $20,000 per year, would not have the full benefits of the “put” component of the fair value, and the fair value could be reduced by 2.4% (with a volatility of 50%).
| Chart 1: Probability of Exceeding $25,000 Limitation based on Contribution Levels | |||||||
|---|---|---|---|---|---|---|---|
| Contribution Amount | TSR Reduction | Grant Date Probability | Fair Value Reduction | ||||
| 30% Volatility | 50% Volatility | 70% Volatility | 30% Volatility | 50% Volatility | 70% Volatility | ||
| $20,000 | -5.9% | 33.0% | 35.3% | 34.8% | -1.7% | -2.4% | -2.8% |
| $15,000 | -29.4% | 3.6% | 11.7% | 16.6% | -0.2% | -0.8% | -1.4% |
| $10,000 | -52.9% | 0.0% | 1.0% | 370.0% | 0.0% | -0.1% | -0.3% |
| $7,500 | -64.7% | 0.0% | 0.1% | 0.9% | 0.0% | 0.0% | -0.1% |
| $5,000 | -76.5% | 0.0% | 0.0% | 0.1% | 0.0% | 0.0% | 0.0% |
Limit #2: Individual Share Limits
In order to establish a grant date for tax purposes, ESPPs must specify a fixed share limitation in their award agreement, representing the number of shares that are limited to purchase, and varies depending on stock price. We have seen the limitation range from 500 shares to 10,000 shares for a given purchase period. To illustrate this modeling though, we first define the term, Fixed Limit Value, which represents the fixed share limit times the current market price of the stock. For example, if the fixed limit is 1,000 shares and the stock price is $20, then the Fixed Limit Value equals $20,000. If the stock price is $50, then the Fixed Limit Value equals $50,000. During periods of significant stock decreases, the Fixed Limit Value can shrink materially.
One way to approximate the discount due to the share limitations is by the Ratio of an individual contribution compared to the Fixed Limit Value. For example, if an individual is contributing $20,000 to the ESPP annually and the Fixed Limit Value is $20,000, then the ratio would be 100%. Similarly, if the Fixed Limit Value is $50,000, then the ratio would be 40% ($20,000/$50,000). Chart 2 below summarizes the potential discounts with ratios varying from 20%-100%. Note that in the example above and a Ratio of 100%, there would be an approximate discount of 2.9% with a volatility of 50%.
| Chart 2: Probability of Exceeding Fixed Share Limitation | |||||||
|---|---|---|---|---|---|---|---|
| Ratio of Contribution to FLV | TSR Reduction | Grant Date Probability | Fair Value Reduction | ||||
| 30% Volatility | 50% Volatility | 70% Volatility | 30% Volatility | 50% Volatility | 70% Volatility | ||
| 100% | 0.0% | 43.9% | 41.9% | 39.4% | -2.2% | -2.9% | -3.2% |
| 80% | -5.9% | 33.0% | 35.3% | 3480.0% | -1.7% | -2.4% | -2.8% |
| 60% | -29.4% | 3.6% | 11.7% | 16.6% | -0.2% | -0.8% | -1.4% |
| 40% | -52.9% | 0.0% | 1.0% | 3.7% | 0.0% | -0.1% | -0.3% |
| 20% | -76.5% | 0.0% | 0.0% | 0.1% | 0.0% | 0.0% | 0.0% |
Next Steps and Estimating Materiality
Chart 1 and Chart 2 above can be used to approximate the discount for any individual or any population to account for the limits (on a weighted average basis). On either an individual participant basis, or looking at cohorts of your population in the aggregate, then approximate discounts can be estimated for your population for both discounts. (Note that there may be some overlap between the discounts, and it isn’t completely additive).
In a time when compliance and pennies matter, these are easy approaches to best approximate the fair value, and ensure compliance with ASC 718. To learn more about how your ESPP limitations may be affecting your valuations, contact your Infinite Equity consultants.
