Employee Stock Purchase Plan (ESPP)

“Right action is better than knowledge; but in order to do what is right we have to know what is right.”
—Charlemagne

By Joe Ferreira and Sam Marshall

 The “Father of Europe” was most certainly not talking about ESPPs when he said this, but he might as well have been. The great part about ESPPs is that it is hard to take a “wrong” action, but some paths may be better than others.

What is an ESPP?

Very simply it is an opportunity to purchase, at a discount (usually 15%), the lower of $25,000 or 15% of last year’s compensation of your company’s stock.

The money you pay for these shares comes from a payroll deduction similar to a 401k. Unlike a (regular) 401k contribution, this money is after tax. ESPP plans are typically set up to work on a 6-month basis where they deduct an equal amount from each paycheck for the entire 6-month period.

As soon as the purchase date passes, your company would assign the shares to your account and you could trade them as you would any other shares. Some companies do place restrictions on selling ESPP shares. Although this is not common, you should read your plan document carefully before selling shares purchased through an ESPP.

Why all the hype?

People love ESPPs and they are a benefit that gets a lot of buzz when companies go public. As discussed above, there is the ability to buy shares at a discount. However, that is not the biggest benefit of an ESPP. The biggest benefit is the “lookback.”

The lookback will check the price at the beginning and end of the period and give you the discount on the lower of the two prices. This means that even if the price falls throughout the 6-month period you will still end up ahead. In fact, the worst you can do is make 17.6% - which is a little higher than the actual discount the company gives you.

How does it work?

For example, say the stock started at $15 per share and ended at $10 per share. You would end up paying $8.50 per share and have a profit of $1.50 (1.50/8.50 = 17.6%).

On the other hand, if the stock goes up, you could reap serious value. Imagine the stock started at $10 and finished the period at $15. In this scenario you would have made a return of over 75% in 6 months! (A profit of $6.50 divided by a purchase price of $8.50 = 76% gain.)

I already own a lot of my company’s stock. Should I really be buying more?

Yes! Diversification has its place but not at the expense of free money. If your plan has a discount and a lookback (most do, though some do not), then this makes sense regardless of how concentrated you are. If you’re concerned about how much of your net worth is in your company, you could sell these shares as soon as possible or sell other shares if you want to wait for these gains to become long-term. This strategy can make a lot of sense, but it is technical and something we’ll cover in another article.

This sounds great but what if I can’t afford $25,000 (or 15% of compensation)?

In a way, you don’t really have to think of this as “paying” for the stock if you have some cash on hand and then sell the stock immediately (or as soon as you’re able if you are subject to restrictions). You don’t need to be in a position to be able to save this money, just in a position to be able to defer receiving it. We wouldn’t advise getting into credit card debt or not taking the full match on your 401k to take advantage of an ESPP, but generally, anything short of that is likely worth it.

What are the tax implications?

Ah…death and taxes. We can’t avoid them. Any discount you receive would be taxed as ordinary income, but all gains would be deferred until you sell the stock. For ESPP stock to receive lower capital gains rates, you must hold the stock for at least one year from the purchase date (the end of the period) and two years from the beginning of the purchase period. In practice, this means you would have to “hold” the stock for 18 months after you receive the shares.

Like most things, every decision is personal, and what is right for one person doesn’t mean it’s right for everyone. ESPPs are a fantastic benefit and if managed appropriately can really improve your financial health. Every plan is a bit different so please be sure to read the plan document carefully.