A whole lot of companies in the tech space offer Employee Stock Purchase Plans (ESPP). These are programs which incentivize employees to buy the stock of their employer company, often at a steep discount. As an engineer just starting out, you may see this and think: Awesome! I love my company and believe in what they’re doing, this is a chance for me to invest in their success. But have you thought about what happens if their stock takes a dive? You not only lose the value of your stock, you also might lose your job! Or maybe you HAVE thought about that, to the extent you’re afraid to participate at all! This is also bad, as some well-structured ESPP programs can yield a guaranteed return well above that of the stock market at large.
I’m going to do some explaining and simple calculations using an example ESPP which is very, very similar to the ones I’ve seen at companies where I’ve worked or interned in the past. This will show you that:
- You should almost definitely participate
- You should almost definitely sell as soon as the stock is in your hands
Setting Up the Problem: How ESPP Works
- Enrolling: It starts with upfront enrollment. You have to say you plan to participate for this ESPP offering period. For most companies, this enrollment period happens once or twice a year (to enroll for a twelve-month or six-month period).
- Your Contribution: When you enroll, you choose how much money you want to put into the plan per paycheck. Most companies cap this at something like 10% of your salary. If your plan is good (and I’ll explain how you figure that out later), you should put in as much money as you can possibly spare from your paycheck, because this is most likely the best investment vehicle available to you right now.
- The Discount: Does your employer let you buy the stock at a discount? Many do, and often this discount is around 15%. The discount is the part that really makes these plans valuable.
- Look-Back Price: Many employers will allow you to purchase the stock at the lowest of two possible purchase prices: the price at the beginning of the plan, or the price at the end of the plan. The discount is then applied to that best of the two prices, and that’s how much you pay for a share. This is an important part of a good ESPP, because it: 1) Guarantees that you will not lose money no matter how badly the stock crashes, and 2) Ensures that you benefit from any gains the stock makes over the 6-month offering period as if you had bought all of the stock when you first enrolled.
So, Should I Participate?
Any stock market guru will tell you that risk and reward are intimately tied to one another. If your ESPP is set up right, you can bust the chain tying these two together and make a fantastic profit. To make ESPP a smart and low-risk choice, you need to ensure two things: that the discount is valuable to you, and the look-back policy is safe.
- Valuable: Whether or not the discount is valuable depends on two things: the value of the discount, and the return you think your money could make if you invested it somewhere else. For example, if your discount is only 5%, and you have a mortgage that sits at around 4%, you’re probably better off investing in the mortgage once you consider taxes. However, if your discount is 15%, you’re almost sure to beat the S&P 500 lifetime average of around 9%, even if you’re in the highest possible tax bracket.
- Safe: If your look-back policy is a safe one–by which I mean it allows you to buy the stock at the lowest of either the price at the beginning of the offering period, or at the end–you have the added benefit of this return being guaranteed. Stock market returns are far from guaranteed, in fact they are quite risky for short-term horizons!
But what about these taxes I keep mentioning? Well, taxation of ESPPs can get pretty complicated. If you’d like to know about the bigger picture, try this article. For now, I’ll keep it simple. If you sell your shares immediately upon receiving them, the full amount of profit from the sale is taxed just like your regular income.
Why should you sell as soon as you receive them? It has to do with maintaining a diversified portfolio. As soon as the ESPP offering period ends and the stocks become yours, you are no longer investing for the guaranteed returns, you are investing in the actual performance of the company. As much as you may like your company, you are already heavily invested in it as it stands: they pay your salary and provide your benefits. If the company were to hit a downturn and lay you off, you would lose your salary and probably most of the value of your stock, leaving you in a really bad place. To keep from being overinvested in a single company, sell your stock as soon as you can.
Returning to the issue of taxes, let’s calculate the return value of an example ESPP. Our ESPP has a 15% discount over a 6-month offering period with a good look-back policy which guarantees you’ll get the lower of the start and end prices. We invest in our ESPP plan starting in May, and by the time November rolls around, our company didn’t do too great. The actual stock price is down 10%! However, due to our wonderful look-back policy, it doesn’t phase us. We smartly sell off all our shares, getting a 15% return on the cash we invested from our paychecks. When tax time rolls around, we report short-term capital gains, because we didn’t hold the stock for long enough to use long-term capital gains rates. Our shares are taxed just like regular income. Since we make about $100,000 a year, the upper parts of our income are taxed at the 28% bracket. With taxes taken out, the return on our initial investment comes out to 10.8%! We beat the stock market average, and we took on no risk while doing it!
Because (in a good plan) there is no risk for a great return, ESPP is an ideal place to invest for a house downpayment, wedding, vacation, or any other near-future goals!