What is an ESPP (Employee Stock Purchase Plan)?

What if your employer offered you to buy their stock at a discounted price? Would you take it? Why would they offer that?

Introducing the Employee Stock Purchase Plan, which provides up to a 15% discount from a stock's closing price on certain dates – which can mean more than 15% instant capital gains for buying in. At my company, someone worked it out and found it to be closer to 22% return on investment.

An ESPP is yet another form of compensation benefit for employees, where they buy in every pay period and are awarded discounted company stocks at the end of a purchase period.

That buy-in comes in the form of payroll deductions. Like most benefits (e.g. insurance and retirement contributions) you never see the money move. You simply receive less money on your paycheck.

That reduction in paycheck will pay off big time, though, as in the aforementioned 22% return. That's better than the average stock market year, which everyone quotes to be around 11%.

At the end of the ESPP's period, all that money that was deducted from your payroll is used to purchase your company's shares for a significant discount – usually 15%, but sometimes 5%.

You can then turn around and sell the stock immediately for those lovely gains.

This all sounds great so far. So what's the catch?

Concerns to consider about Employee Stock Purchase Plans

Well for one catch, you're tying up your cashflow in a payroll deduction for half a year. This is problematic if you don't have a cash and credit buffer. Yet as FI-minded individuals, you will hopefully not be scraping by with your cashflow if you're being offered an ESPP.

Another catch is that if you hold onto those stocks, you're exposing yourself to the risk of a single company. If the share price plummets 15% or more, then your gains are wiped out. Then again, this isn't a particularly unique risk – nobody likes it when their stock picks go down, but that inevitably happens to some.

Thirdly is that your taxes get complicated by selling ESPP stocks. Loosely glossing over the complicated rules, there's two situations where you sell the stocks: disqualifying (you sold them soon) or qualifying (you sold them after waiting a set period, usually 1.5 to 2 years).

In disqualifying situations the discount and any capital gains are taxed as ordinary income, since they're direct compensation from your employer.

If you instead wait to sell the shares more than 2 years after the offering date, then the 15% discount is taxed as ordinary income, but any further capital gains beyond the discount are taxed as long-term capital gains.

Thus emerges two main strategies: to treat the discount like a source of extra compensation and sell immediately to diversify, or to hold long-term to minimise taxation.

Why do companies offer ESPPs?

Let's pretend to be optimistic, trusting people and start by believing that employers offer ESPPs for purely altruistic reasons. There's a surprising few!

For one, ESPPs are a cheap and easy way to introduce employee ownership into the workforce. Encouraging employees to purchase stock with the company discount ends up with more people holding onto the stocks, and it leads to more employees being invested in the company's success.

Employee-owners tend to be more productive and less likely to churn, a lesson you can also find with Employee Stock Ownership Plans or worker cooperatives.

However, employee ownership is a cultural attitude that must be embraced at all levels. Simply having an ESPP (or ESOP) does not magically transform your employees into employee-owners.

ESPPs also are a voluntary programme, giving workers the choice to participate, and to choose when they wish to sell their stocks. Ostensibly this is good, although the default is to opt-out which could be considered a downside. It's useful to have lots of messaging encouraging employees to participate, but they're not forced to accept the benefit.

ESPPs are on shorter time horizons than restricted stock units, which typically have vesting schedules that measure in years and cause net worth cliffs when they vest and plateaus when you're waiting on them. An ESPP is more consistent, though not as regular as a paycheck.

Now that we're done believing things are rosy, let's remember that in the real world people act with self-interest, and money is often the underlying mover. From the company's perspective, there's some distinct advantages to ESPPs:

The number one reason is to preserve cashflow in a company. Those payroll deductions to purchase stock means that the company doesn't need to have as much cash on hand every pay cycle. That capital can be reinvested into growth instead, or to smooth out revenue.

Another reason is that offering an ESPP usually means no taxation consequences, which is not as good as a deduction but it's close enough. It's essentially a no-cost benefit companies can offer.

Companies want to offer ESPPs to be competitive, as a large number of companies (especially a majority of tech companies) offer ESPPs. Companies want to attract top talent, so they're forced to match their competing companies in benefit packages.

This works because ESPPs are considered "broad based." They can be offered to nearly any employee, in many countries equally. Though participation often comes with restrictions such as a minimum amount of hours worked per period, or a year's tenure with the company before it begins.

Also, because ESPPs are opt-out, some employees will metaphorically "leave money on the table" in terms of their total compensation and not participate. This is similar to not contributing to get a 401k match – usually a company reduces salary by the amount of the match, so opting out of the programme results in a gain for the company.

What's the summary of Employee Stock Purchase Plans?

In short: if you're offered an ESPP, you should take it unless you have some serious cashflow issues going on.

They're a token programme for employee ownership, something that I'm always excited to see. Though an ESPP-offering company is not likely to be majority employee-owned company. It's most likely to be a tech company, or other big corporation with external shareholders.

ESPPs are a worthwhile benefit, and you should keep an eye out for them when considering where to work. Do your research when considering offers!