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Employee Stock Purchase Plan

The Employee Stock Purchase Plan: Easy Money & Guaranteed Returns

Let’s talk about free money for a second. In the financial community, the topic of “free money” typically refers to an employer’s matching 401k contribution. But today I am going to talk about a different form of free money. Today I am going to talk about the Employee Stock Purchase Plan (ESPP) and how this plan also provides “free money” by locking in a guaranteed return.

TL;DR: If your employer offers an Employee Stock Purchase Plan, you can lock down guaranteed returns. Period. No gimmicks; It’s the real deal (seriously).

It's true

But let’s back up a little bit and get into the details of the employee stock purchase plan.

To simplify things, I am going to use my employer’s ESPP as an example, so we don’t have to deal with ambiguity.

Ready? Let’s get started.

What is an Employee Stock Purchase Plan (ESPP)?

In short, an employee stock purchase plan is an employer-sponsored program that allows you to purchase your company’s publicly traded shares at a discount. The discount typically ranges from 10-15%

Notice it is only for publicly traded shares – this means your company must be public and must be traded on the stock exchange in order for them to offer an ESPP.

There are two important time periods to understand with the ESPP: the Offering Period and the Purchase Period:

  • Offering Period: This could also be called the enrollment period. The offering period is when you will accumulate payroll deductions to purchase the company stock. My employer’s offering period is each quarter (ex: Oct 1st – Dec 31st). During this time, your contributions (payroll deductions) will build with each pay period.
  • Purchase Period: This is when the shares are actually purchased using the money accumulated during the Offering Period. Typically plans work in a way that you are offered a discount on the lowest price between the closing price of the stock on the beginning and end of the Offering Period. For example: The company stock price is $100 on October 1st and $105 on December 31st. The discount is offered on the lowest of these two prices, or $100.

Unlike a 401k, the ESPP is funded with after-tax dollars and is funded completely by you. You choose the amount you wish to contribute. Contributions are then taken directly from each paycheck and accumulate during the Offering Period. Those funds are then used to purchase the discounted stock once the Offering Period has ended.

Taking Advantage of the ESPP

Recall – the whole idea behind the employee stock purchase plan is to offer employees shares of the company stock at a discounted price. The discount is the crux of it all and is what guarantees a positive return.

Here is how it works:

    1. An employee checks with their benefit center and finds out their employer offers an ESPP with a 15% discount. The employee gets very excited about this.
    2. The employee contributes $200 per paycheck to the ESPP over the Offering Period of October 1st – December 31st. There are 6 pay periods during this time (bi-weekly). Therefore, during this contribution period the employee accumulates $1,200 of contributions.
    3. The stock market does whatever it wants during this time and it is now January 1st.
    4. The stock price on October 1st was $50 and it increased to $55 on December 31st. Because the plan purchases the discounted shares at the lowest of these two values, the shares are purchased at $42.50 each ($50 x 85%). The employee now owns 28 shares of the company stock with price basis of $42.50.
    5. The savvy employee immediately sells the shares at the current market price for a guaranteed return.

Guaranteed Returns

This is where things get good.

As long as the share are sold immediately after being purchased, the employee and locked in a guaranteed return.

Imagine if the price had remained the same over the same time period. It started at $50 and ended at $50. The employee gets 15% off the price and is therefore able to purchase it for $45.50 ($50 x 85%). By selling immediately, at $50 per share, the employee earns a return of 17.6% { (($50-$42.50) / $42.50) x 100  }.*

The kicker in the original scenario is that the share price increased during the offering period, from $50 to $55.

Since the employee sells the shares immediately, they are able to sell them at $55 each.

28 shares x $55 = $1,540 ← this represents a 28% return!

28% Return

But what if the inverse were true? What if the stock price decreased during the offering period?

No fear, friend. Even if the price decreased, the employee still gets a 15% discount on the price, and by selling it immediately is able to lock in that return. So if the price went from $50 to $45, the employee is able to buy it at $38.25 and sell for $45. 

Tax Implications

Naturally, there are tax implications with anything this good. Since you are selling the shares right away to lock in the return, you will have to pay short-term capital gains tax on the earnings.

This is completely worth it.

No one can predict the stock market, and holding the shares until they qualify as long-term is risky.

Take the returns now and pay the taxes. It is a no-brainer.

Turbo Tax does a good job of explaining the tax implications of the ESPP.

Recap

The ESPP is a seriously powerful investment tool. It is another form of free money that is too good to pass up.

This is by no means a substitute for tax advantaged accounts like a 401k and HSA, but it is a nice supplement to these. Max your tax advantages, then get on the ESPP game.

As a reminder:

  1. Find out if your employer offers an ESPP.
  2. If they do, enroll ASAP, contributing what you can after your tax advantaged accounts are taken care of.
  3. Sit back, relax and don’t concern yourself with the share price. You get it at a discount no matter what.
  4. Once the shares are purchased, immediately sell and capture the 15%+ return.
  5. Pat yourself on the back for being so financially savvy, then repeat.

Free Money

What are you waiting for? If you employer offers an ESPP, you need to take a look at it ASAP.

*Thank you, Malcolm, for pointing out that the minimum guaranteed return is actually greater than the discount due to the mathematics of calculating the percent gain. Example:

  • 15% discount; $100 share price;
    • $100 x 85% = $85
    • (($100 sale price – $85 purchase price) / $85 purchase price) x 100 to convert to percentage = 17.6%
    • 17.6% return > 15% discount
  • 10% discount; $100 share price;
    • $100 x 90% = $90
    • ($100 – $90) / $90 x 100 = 11.1%
    • 11.1% return > 10% discount

8 thoughts to “The Employee Stock Purchase Plan: Easy Money & Guaranteed Returns”

  1. Very nice post. Thank you for the theoretical timeline. I think it’s super helpful for understanding the cycle. It was my first question.

    Our discount is 5%. I’m looking into to see what I’d be interested in throwing in.

    1. Yes the timeline can be a little confusing due to the way they word things. All a matter of making sure you understand it. Talking to the provider can help clear up questions as well. Let us know what you end up doing!

    1. Sweet! I’m glad you found this post useful. Make sure to take a look and understand how the offering and purchase periods work with your plan specifically. They tend to be similar across companies, but each one can still be a little bit different. Even a few dollars a paycheck can net a nice return!

  2. In the 15% discount situation, I believe the minimum rate of return is actually 17.6%. If you buy $100 of stock for $85 and turn around and sell for $100, your basis is $85. A $15 gain on $85 is 17.6%.

    1. You are, mathematically, correct 🙂 I have adjusted the post to note that the minimum return is actually greater than the discount, whatever that discount % may be. (typically ranging from 10-15%).

      It’s a good point that people should be aware of – it makes even more enticing! So, thank you.

      The point I was trying to make is that the returns are locked in if the shares are sold immediately rather than holding them long term and risking loses. 15% or 17.6%, it’s still worth it.

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