Employee Stock Purchase Plan (ESPP) Explained – Should You Buy?

An Employee Stock Purchase Plan (ESPP) is a program by which employees can purchase their employer's stock at a discount, but there are a lot of nuances to consider. Here I review the pros, cons, and some lesser known risks and strategies of ESPP's.

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What Is an Employee Stock Purchase Plan?

As the name suggests, an Employee Stock Purchase Plan – or ESPP for short – is a program by which employees are allowed to buy shares of their employer's stock at a discount. Roughly half of public companies offer one.

This is usually a voluntary benefit of employment, so the employee can choose whether or not to participate. If opted in, funds are deducted from the employees paycheck to accumulate and buy shares of stock at a predetermined price that is below the fair market value.

That discount usually ranges from about 5% to 15%. For example, if the current fair market value is $10 per share, you may be able to purchase that stock at $9 per share.

Next we'll discuss the benefits of an employee stock purchase plan.

Employee Stock Purchase Plan Benefits

There are several somewhat obvious benefits of an ESPP.

First, it allows the employee to quite literally invest in the company and share in the employer's future financial success. In that sense, the employee's time and effort can directly impact their own wealth by helping to grow the company, giving the employee a tangible incentive to be more productive.

Secondly, this investment program is pretty simple for the employee, as deductions are happening automatically and the employer is handling the paperwork and logistics of accumulation and stock purchases. Your money accumulates during the offering period and is later used to purchase shares during the purchase period. All you need to do is enroll and choose a percentage of your paycheck to contribute.

The most important benefit is your ability to purchase shares at a discount, which may allow for greater future growth.

Now let's go over some drawbacks and risks of an employee stock purchase plan.

Employee Stock Purchase Plan Drawbacks and Risks

ESPP's may sound like a great idea but there are a few drawbacks.

First, shares of stock are purchased with after-tax payroll deductions, so recognize this is not like a 401k or Traditional IRA for which contributions are tax-deductible.

Secondly, investing in a company's stock can be risky, as that company can decrease in value and/or go bankrupt, in which case your stock shares would be worth less or possible nothing. As with most investments, there is no guarantee of a positive return. Often the company's potential for failure is likely outside the control of a single employee who may own a significant amount of stock.

Third, the company may already be overvalued, so that discounted purchase price may not be as juicy as it sounds. If you buy stock at a 10% discount and then it later drops by 20%, the discount didn't really help you much.

Zooming out, recognize too that stock picking tends to underperform the market. For U.S. stocks from 1926 through 2017, in terms of lifetime dollar wealth creation, only 4% of stocks accounted for the net gain above T-bills. As such, the odds are very much stacked against a single company beating the broader stock market.

Similarly, hopefully it also requires no explanation that investing heavily in a single company's stock creates significant concentration risk. The level of that concentration is much higher than you probably think, as your human capital and wages are already directly linked to the same company. Index investors like myself are usually aiming to maximize diversification, at least within one asset class. I would never buy my own employer's stock if not at a discount.

This is obviously especially risky for those who for some reason are hoping to use the bulk of their ESPP shares to save for retirement.

Conclusion – Should You Invest in Your ESPP?

So should you invest in your company's ESPP? Maybe.

That discounted purchase price and the sheer psychological impact of having real “skin in the game” with your employer may be extremely valuable. Just be sure to keep the aforementioned drawbacks and risks in mind.

My general rule of thumb for stock pickers who want to keep things fun and interesting is to keep that speculation at no more than 10% of the total portfolio. As such, I'd limit employer stock ownership to 10% of your total portfolio so that it doesn't wreck your financial future if things go awry.

As I mentioned earlier, selling the stock as soon as possible – to then go buy other, more diversified assets – mitigates some of those drawbacks and risks but most plans prevent you from selling immediately, and any gains on shares held for less than a year will be taxed at a higher rate as short term capital gains, as opposed to long term capital gains if held for longer than one year.

Be sure to read the fine print. Plans can differ in terms of lengths of accumulation and purchase periods, tax treatment on purchases and sales, refunds if you change your mind, discount rate, and the inclusion of features like a “lookback,” which compares the value of the stock at the beginning of the offering period and the value on the purchase date, and then uses the lower of the two as your purchase price.

My strategy would be to always sell as soon as possible. In this protocol known as flipping, you sell the shares as soon as they hit your account. In that sense you'd essentially be locking in profit quarterly or semiannually and paying a small tax to be able to diversify and not concentrate further in a single company. You get to extract “free money” and go invest it as you wish elsewhere.

I usually say diversification is the closest thing to a free lunch with investing. Flipping an ESPP may be another one.

In my opinion, holding the ESPP shares for longer than required makes little sense rationally, as it creates the non-trivial risk of your shares potentially being wiped out completely, as well as the obvious opportunity cost of not being able to utilize the time value of money on other investments. If you think that risk is negligibly small, go talk to folks from Lehman Brothers who were holding company stock in 2008.

Many intuitively think sitting on shares and waiting for favorable tax treatment is advantageous. Don't let the tax tail wag the dog, and realize that whether or not you feel confidence in your gut about the future financial viability of the company has little bearing on its realized performance.

But again, the nuances of ESPPs can be complex and can differ among plans, and not all plans allow you to immediately sell purchased shares, so it may be wise to consult your tax professional and financial advisor.

As usual, start by defining your own personal goal(s), time horizon, and risk tolerance to assess whether or not participating in an ESPP is appropriate for you.

Do you participate in an employee stock purchase plan? Let me know in the comments.

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