What Do I Do With My ESPP?
Over the past few weeks, I received questions and concerns about Employee Stock Purchase Plans (ESPP). Some of them were:
“I have an ESPP, how does it work?”
“Should I use my ESPP to buy company stock?”
“Does an ESPP involve equity ownership?”
“I have one, but I don’t understand the discount.”
ESPP Overview
An ESPP may be one of the best employee benefits in your compensation package. Typically, all employees can enroll in an ESPP through their Human Resources department. ESPPs allow regular, ongoing purchases of your employer’s stock through post-tax payroll deductions. Many of these plans offer a discount, making it possible to buy shares at a lower price than if you bought them on the open market.
The highest discount a company can offer is 15% from the stock price. Additionally, some plans include a lookback provision. For purposes of illustration of a lookback provision, let’s assume that your company’s discount is 15%. In this case, a lookback provision applies a discount of 15% from the lower of the price on the Offering Date or the Purchase Date. More on Offering Date and Purchase Date below. This is a risk-free 15% return!
How They Work
You have a right but not the obligation to participate in an ESPP. If you participate, you buy shares of the company through a payroll deduction. The purchased stock is held in an investment account, not a retirement account.
The Offering Period is the time to purchase stock under the ESPP, and it begins on the Offering Date and ends on a predetermined Purchase Date. The Purchase Date is always at the end of the Offering Period. Here are some examples to better illustrate the concepts.
ESPP Examples
Company Alpha
Company Alpha uses a 15% discount with a six month lookback.
The Offering Date price is $10.00 and the stock price on the Purchase Date is $12.00. Your purchase price is $8.50 (15.0% discount from $10.00). Your price increase is 41.2% ($3.50 spread at purchase divided by $8.50 purchase price).
If the price fell to $6.00 on the Purchase Date, your purchase price would be $5.10. Your gain is 17.6% ($0.90 spread at purchase divided by $5.10 purchase price).
In both cases, the gains are much larger than 15%.
Company Beta
Company Beta uses a 10% discount with a six month lookback.
The Offering Date price is $10.00 and the stock price on the Purchase Date is $18.00. Your purchase price is $9.00 (10.0% discount from $10.00). The price increase is 100.0% ($9.00 spread at purchase divided by $9.00 purchase price).
If the price fell to $7.00 on the Purchase Date, your purchase price would be $6.30. The gain is 11.1% ($0.70 spread at purchase divided by $6.30 purchase price).
In both examples, the gains are higher than 10%!
Company Gamma
Company Gamma uses a 10% discount and a six month offering period. There is no lookback.
When the stock price on the Purchase Date is $15.00, your purchase price is $13.50. Your increase is 11.1% ($1.50 spread at purchase divided by $13.50 purchase price).
If the stock price fell to $12.00 on the Purchase Date, your purchase price would be $10.80. The increase is 11.1% ($1.20 spread at purchase divided by $10.80 purchase price).
The price increase is higher than the discount, but not as high as the first two examples. You can see how advantageous a lookback period is for an ESPP.
Considerations
There are a lot of considerations for an ESPP. Some of them are cash flow, investment risk, and income taxes.
Cash Flow
If you choose to participate in an ESPP, you will have to decide what percentage of salary you will contribute to the ESPP. The contributions come from your paycheck, so the higher the contribution, the lower the take-home pay. You may want to consider how your participation in an ESPP will impact your reduced cash flow.
Investment Risk
Participating in an ESPP means you will buy shares of company stock. Depending on your situation, you develop and commit ahead of time to a strategy for holding or selling your shares. Your strategy should depend in part on investment risk, and how concentrated your position is in the stock of your employer. If you take no action, you could have a large position in the stock and it may not fit in with your overall investment plan. If the stock price increases, that’s great! However, accumulating too many shares could leave you overexposed and wipe out significant wealth if the stock price decreases.
Income Taxes
There are holding period requirements for ESPP shares. A qualifying disposition meets the following requirements:
1.) The sale of your shares is at least 2 years from Grant Date
2.) The sale of your shares is at least 1 year from Purchase Date
For a qualifying disposition, the discount from the purchase price received will be taxed as ordinary income, and the other gains will be taxed as a long term capital gain.
Failure to meet the two requirements results in a disqualifying disposition. Ordinary income tax applies to the gain between the purchase price of the stock and the Purchase Date price. The rest is taxed as a capital gain or loss.
You may think that the better tax treatment of a qualifying disposition is a better choice. However, it’s a long holding period (2+ years from Grant Date and 1+ year(s) from Purchase Date). During this time period, the stock price will fluctuate and you may have less after tax, although at a lower tax rate, than if you sold immediately after the shares were purchased.
ESPPs are a great benefit for you, so make sure that you have a plan on how to use them. This is a lot of information and if you have any questions, you can set up a free consultation.