According to the 2018 Deloitte Global employee stock purchase plan trends survey1, participation in Employee Stock Purchase Plans is relatively low. This low participation rate is often because the plan details and benefits are not communicated effectively to employees, which is unfortunate given the benefits that many employees may be missing out on by simply being uninformed and uneducated.
An Employee Stock Purchase Plan (ESPP) is a benefit that many publicly traded companies offer to employees (and employees of their subsidiaries) to purchase company stock through payroll deductions at a discount of up to 15%. Employees who chose to participate in the plan contribute to an account through payroll deduction similar to the way that other employee benefits are paid for.
The money is held in an account in cash until the Offering Purchase Date. At that time, the money in the account is used to purchase as many whole shares of the company stock as possible. Any money left over will remain in the account until the next Offering Purchase Date when shares will be purchased again.
How Does an Employee Stock Purchase Plan Work?
I provided the basics about how an Employee Stock Purchase Plan works above, but there’s a lot of jargon thrown around when it comes to these plans. Here are some of the terms that you need to know:
Enrollment Period
Similar to an employee benefits enrollment period, this is the time when you choose whether or not you want to participate in the ESPP and how much of your income you would like to contribute to it as a percentage of your pay.
For example, you can see that enrollment period for the Salesforce ESPP is twice per year in May and November. Similarly, many ESPPs have two enrollment periods each year (although some may only have one).
Offering Period
This is the time when payroll deductions are contributed to the ESPP account and are accumulated until you purchase shares. You can often see the accumulated balance of your ESPP cash on your paystub. Continuing with the Salesforce example above, the two offering periods would be December-June and June-December.
Another example is LabCorp’s ESPP which has two offering periods as well. The first period begins on the first trading day of January and ends with the last trading day of June while the second period begins on the first trading day of July and ends on the last trading day of December.
Purchase Period/Purchase Date
The purchase period is really the purchase date. This is the day within the offering period when the plan administrator uses the money that you have contributed to your ESPP account to purchase company stock for you. The purchase date is typically the last trading day of the offering period.
Purchase Discount
The purchase discount is the main reason that someone may participate in an ESPP. On the purchase date, the purchase price of the company stock will be discounted according to the plan document. Companies may offer different discounts on their ESPP, but they typically are between 5-15% (with a maximum discount of 15%, or 85% of Fair Market Value, according to the IRS).
Lookback Provision
Many ESPPs provide a lookback provision which allows you to purchase company stock at an even larger discount than 15%. If the IRS says that the maximum discount that you can receive is purchasing at 85% of Fair Market Value, then how can you purchase at a greater discount than that?
The lookback provision allows you to purchase stock through the ESPP at 85% of Fair Market Value (a 15% discount) on the date the offering period begins or the Offering Purchase Date, whichever value is lower. This means that the minimum discount you’ll receive is 15%, but it could be higher. Not all ESPPs have this benefit.
Here’s an example of making a purchase without a lookback provision:
Fair Market Value of company stock at offering date = $100
Fair Market Value of company stock at purchase date = $125
Discount = 15%
Purchase Price = $106.25 ($125/share x 1-15%)
And here’s an example of making a purchase with a lookback provision:
Fair Market Value of company stock at offering date = $100
Fair Market Value of company stock at purchase date = $125
Discount = 15% of lower of offering date price or purchase date price (lookback provision)
Purchase Price = $85 ($100/share x 1-15%)
While the example above is often how lookback periods work, your company may offer something different. LabCorp has a unique lookback provision. The LabCorp ESPP lookback allows company stock to be purchased at the lesser of 85% of the average of the high and low sales price of the stock on the offering date or the last trading day of the offering period. It’s important to know that not all lookback provisions are the same.
IRS Purchase Limit
While Employee Stock Purchase Plans typically allow employees to contribute a maximum of 10-15% of salary, they are limited by IRS regulations. The IRS limits ESPPs to allowing employees to purchase a maximum of $25,000 in fair market value of company stock per calendar year. Additionally, the purchase discount is limited to 85% of the fair market value of the stock. So, if you receive a 15% discount, then you can contribute $21,250 to the plan each year.
Maximum Purchase (Fair Market Value) = $25,000
Discount (15%) = – $3,750
Maximum Contribution = $21,250 (or $10,625 every 6 months)
Should I Sign Up for My Employer’s ESPP?
There are a couple of things you need to take into consideration before deciding whether or not you should sign up for your company’s Employee Stock Purchase Plan. The first is to make sure that you have a solid financial foundation in place.
Build A Solid Financial Foundation First
Contributing to an ESPP means that you could have money tied up for 6-12 months that may otherwise be more beneficial elsewhere in your financial plan. Before considering contributing to your Employee Stock Purchase Plan, you need to be sure that you have a solid financial foundation in place. What does that mean?
Here is what I believe to be the key pillars to a solid financial foundation:
- 3-6 months of cash in an emergency fund
- No high interest rate debt
- Proper insurance coverages in place
- A debt paydown strategy for your other debt
- A savings strategy (for retirement and short-term goals)
- Contributing at least 15% of your income to increasing your net worth
Know The Specifics of Your Employer’s ESPP
As we saw above, there are a lot of different pieces that go into an ESPP and the specifics of your employer’s plan could be significantly different than the examples I’ve provided. You need to read the plan document to be sure that you know how it works and how it fits into your personal financial plan.
Have A Strategy
Finally, you need to create a strategy for how you’re going to utilize your company’s ESPP. It’s important to have a plan in place for what you’re going to do with the stock that you receive through your ESPP.
An ESPP can be a great benefit, but you won’t get the most out of it if you don’t go in with a plan. There are plenty of questions that you need to answer for yourself to make sure that you create a sound strategy:
- What are you going to do with the stock?
- Quick sell it upon receipt (a disqualifying position, which means that gains are taxed at ordinary income tax rates)?
- Hold it until it becomes a qualifying disposition, which allows gains above the discount to be taxed at long-term capital gains rates (the discount will still be taxed at ordinary income rates)?
- How much of the proceeds will you hold back for taxes and where will you keep that money?
- How much of your portfolio are you willing to have concentrated in your employer’s stock?
- Portfolio diversification is important and concentration in one stock is risky.
- If you sell the stock immediately to take advantage of the discount, then what are you going to do with the money?
- Bolster your savings account?
- Save it for a bigger goal?
- Invest back into your portfolio in a more diversified allocation?
An Employee Stock Purchase Plan can be a great benefit to many employees, but it’s important to know how it fits into your current financial plan and whether or not right now is the appropriate time for you to take advantage of it.
1 2018 Deloitte Global employee stock purchase plan trends survey
