If you work for an employer that offers an employee stock purchase plan (ESPP), these plans can be an incredibly valuable benefit, and it's absolutely worth your time to consider enrolling.
Your first step should be to familiarize yourself with the basics on what an ESPP is and how it works. Next, you'll want to look into some of the key features of your employer's plan, such as:
- Discount rate or match. Most, but not all, ESPPs let employees buy shares at a discount. The most common discount is 15%, but some plans offer 5% or 10%. Other plans may offer a match instead of a discount. ESPP plans that offer a discount (or match) provide powerful potential for returns over shorter-term periods.
- Lookback provision. Plans with a lookback calculate the price you pay for each share based on the stock price on the first day or the last day of the purchase period1—applying the discount to whichever is lower. A lookback feature adds more value when the stock price is rising.
- When can you sell the shares. Most plans allow employees to sell shares as soon as they receive them. However, about 20% of plans require employees to hold their shares, generally 3, 6, or 12 months, before they can be sold.
Once you have a grasp on the basics, consider learning about some of the finer points of your ESPP, such as tax implications when selling your shares, how often shares are purchased and deposited into your account, and what happens if you need your money before the purchase date.
3 potential sources of returns
To understand the potential value of your ESPP, it can be helpful to separate the ways an ESPP plan can potentially generate a return:
- Discount rate. Any discount offers a built-in source of return. Suppose your plan offers a 15% discount, and on the purchase date your company's shares trade for $100. You would only pay $85 per share, and you would receive shares worth $100. If you sold your shares, you would realize that $15 per share gain, before accounting for taxes—that's a 17.6% return on your investment. (If you hold the shares, the stock price may fluctuate and when you sell, your return could be higher or lower than $15 per share.)
- Lookback provision. A lookback provision has the potential to add to returns. How much it might add will vary with the stock's performance. Suppose that over the offering period, your company's stock rises in price from $100 per share to $110 per share. With a lookback, your price would be calculated on the lower of those 2 prices. Plans with a lookback almost always have a discount, as well. With a 15% discount, you would pay only $85 for shares worth $110, which is a 29% return on investment on the date of purchase. (If, by contrast, the stock price declined over the purchase period, such as from $100 to $90, your price would still be based on the lower of the 2 prices, less the discount—$76.50 per share when the stock is trading at $90 if your plan had a 15% discount, delivering a 17.6% return on the date of purchase. )
- Company match. Some ESPPs offer a company match. The match can be a a contribution match (e.g. a 20% contribution match means that for every $100 you contribute your company contributes $20 towards your purchase of company stock) or a share match (e.g. for every 3 shares you purchase, your company matches 1 share.) Whether a contribution match or a share match, ESPPs with matches means you'll end up with more shares than you could have purchased with your own contributions.
Harnessing an ESPP over the longer term
While the short-term return potential of an ESPP can be powerful, so can the potential for longer-term returns for those interested in a more sophisticated and hands-on strategy.
A common objection to ESPP participation is the impact it has on take home pay. Because ESPPs are only funded through payroll deductions, participation means that your paycheck shrinks. As a result, employees may not be able to take full advantage of the opportunity.
A more sophisticated strategy to allow greater participation would be to sell some or all of the shares after each purchase and use the sale proceeds to offset the reduction of take home pay for the next purchase period.
For example, if you contributed $5,000 (representing 5% of your pay) to the ESPP, and purchased stock worth $6,470 (which represents a 15% discount and a lookback when the stock had appreciated 10%), you could sell your newly acquired shares and be in a position to comfortably contribute $11,000 (11% of pay) to the ESPP in the next period. This strategy offsets the impact of larger payroll contributions with funds generated through the sale of shares.
As a matter of practicality, your company will require any increases in payroll contributions for the next period to be elected before your first lot of shares is purchased, but your elected increased payroll deductions will begin after the first purchase has happened. This strategy can potentially allow the returns from the discount and the lookback to compound, and over time, those compounded potential returns could really add up.
While the potential outcomes may be impressive, there are also real-world complexities to keep in mind if considering a long-term ESPP strategy. Additionally, maximum payroll contributions are typically limited to 10% or 15%, and for most plans there is an annual purchase limit of $25,000 on the value of stock that can be purchased per year, which participants would need to be aware of and plan around.
Is participating in your ESPP worth it?
For many people, participating in their company's ESPP will turn out to be worth it because the great majority of plans offer a discount or match, discount plans, and many also offer a lookback. As we see above, the presence of those features means participating can help to generate returns over shorter-term periods such as 1 year or less, and potentially help generate competitive longer-term returns for those interested in a more hands-on strategy.
Should you participate in your ESPP?
Knowing that your ESPP might be "worth it" doesn't necessarily mean that participating is right for your situation. For many people, it makes sense to first check a few other boxes off of their financial to-do lists—like building an emergency savings, participating in employer retirement matching, or paying off any credit card debt. Also, you should consider that if the value of your stock goes down and you sell, you may not recoup the amount you contributed in your ESPP.
Once you're standing on a solid financial foundation, participating in an ESPP that offers a discount, lookback, and/or match can potentially be a powerful tool to help generate returns and grow your money.