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ESPP explained in layman’s terms (employee stock purchase plan)

Employee Stock Option Plan

Take responsibility for your career and your retirement

Employee Stock Purchase Plan (ESPP)

I just read a stat that stated that the average American household has less than $5000.00 in savings for retirement. With the start of a brand new year, I thought it might be a good time to help folks with new years resolutions and think about increasing the nest egg. Today we are talking Employee Stock Purchase Plans.  

The Employee Stock Purchase Plan or ESPP for short can be confusing. This is different from an Employee Stock OPTIONS plan where a company grants stock OPTIONS to an employee.  With the new year approaching and most of us making new year resolutions, I thought today would be the perfect opportunity to discuss our saving plans for the future.

This post breaks down the mechanics of the program and WHY an employee should consider participating. I have worked in Fortune corporate companies and I have worked in tech companies. I have participated in the company ESPP plan and a Stock Option plan at prior companies, and I am a fan of both. Companies usually have one OR the other so as employees, we usually don’t have a choice in which plan is available. 

Guest Poster @barstonel

A great friend and a guy with serious intellectual horsepower was gracious enough to write a guest post on ESPP’s. He helped me with a blog post earlier in the year on 401K’s and I feel fortunate to have him present today. He has a similar attitude towards life and career as I do. We both believe that as individuals, we need to take control of our own destinies. We should not rely on a company to take care of our career or our finances in retirement. The company can provide career opportunity but they are not going to give it to us. Similarly, the company can provide tools so we can set ourselves up for financial success, but we need to take advantage of them. 

He has a blog which I am proud to share with you here. In close to 10 years of blogging, he is the first guest poster I have hosted and I hope he weighs in again in the future. You can check out his site here at https://barrettnelson.com/.  You will see very quickly, he is not your typical bean counter. 

Workplace Benefits: ESPP

One of the most under-appreciated workplace benefits is the Employee Stock Purchase Program (ESPP). The ESPP can be one of the most lucrative benefits offered, but according to Fidelity, only a third of employees participate. Consider yourself lucky if your company offers an ESPP! Details of each company’s ESPP can vary, but in this post, I’ll describe the benefits of the most common type.

How it works

Employees contribute up to 15% of their salary to the ESPP (they can pull their money out anytime). After six months, the savings are used to purchase company stock. Here is where it gets interesting…the sale price is set by the company: 15% discount off of either the stock price at the beginning of the period or the stock price at the end of the period, whichever is LOWER. Employees can then keep or sell their stock.

The math

Here is an example:

  • Employee contributes $1,000 over six months. The stock price at the beginning of the period was $10, and at the end of the period, it was $11. The stock purchase price is 15% off of the lower of the two prices ($10 – 15% = $8.50). At the end of the period the employee receives 117 shares of stock ($1,000 contribution / $8.50 share price = 117 shares) worth $1,287 (117 shares * market value of $11 = $1,287). The employee can sell the shares for a 29% return.

Hey, wait! What if the stock goes down over the period?

Here is the same example with a lower stock price at the end of the period:

  • Employee contributes $1,000 over six months. The stock price at the beginning of the period was $10, and at the end of the period, it was $9. The stock purchase price is 15% off of the lower of the two prices ($9 – 15% = $7.65). At the end of the period the employee receives 130 shares of stock ($1,000 contribution / $7.65 share price = 130 shares) worth $1,170 (130 shares * market value of $9 = $1,170). The employee can sell the shares for a 17% return.

The average return for ESPP programs is 31.3% according to Fidelity. For reference, the average savings account return is 0.06%.

Why do so few participate?

  1. Because this is not intuitive and optional, many don’t bother learning about this benefit.
  2. Saving is painful. Contributing to the ESPP means a lower paycheck, but participants receive their contributions plus gains back twice a year. Essentially like two extra bonuses each year.
  3. Underappreciated opportunity. There is no limit to the gains. If your company stock price doubles from $10 to $20 during this period, your contributions more than double ($1,000 contributed becomes $2,340).

Don’t leave compensation on the table!

If your company offers an ESPP, take part! It is part of your compensation package, so do not leave money on the table. If it is difficult to start contributing, you can start small and increase your contribution percentage over time. You will not regret it!

HRNasty
nasty: an unreal maneuver of incredible technique, something that is ridiculously good, tricky and manipulative but with a result that can’t help but be admired, a phrase used to describe someone who is good at something. “He has a nasty forkball”.

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  • gander2112

    Good post, but two points to make.

    1) I really can’t afford to fund both my 401K and participate in ESPP. In my opinion, unless you are fully funding your 401K, you shouldn’t participate in the ESPP, because that is a “benefit” that will impact your taxes today, not when you retire.

    2) Last time I participated and had the 15% discount of the lowest start/end was way back in 2001, and participating in it caused me to have an AMT obligation that really hurt to pay that year.

    Add to that, and the fact that the last three companies I have been at it wasn’t 15% off of the lowest, but 15% off the price on the period closing, it was a less than attractive deal (a fact confirmed by my accountant).

    Lastly, unless you buy and sell right away (triggering your recognition of capital gains instantly) you run the risk of having a lot of your portfolio in your employer’s stock, a less than ideal consideration.

    Of course, for many people, especially early career people, if you can afford it, do it, but beware that there are some potentially serious downsides.