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ESPP

By Edited Nov 13, 2013 0 0

Employee Stock Purchase Plan (E.S.P.P.)

Dollar

Employee Stock Purchase Plans are a tax efficient method for publicly traded companies to compensate employees with stock of the company they work for, rewarding them for their service and ingraining a sense of ownership in the company. For the employee the benefits are also tangible; you receive the stock at a discount to the fair market price, in some cases up to 15% for the market value. 

The typical scheme is as follows:

  • You contribute anything from 1% to 15% of your after tax wages to the E.S.P.P.
  • At the end of the six month period your employer uses those funds to purchase shares in the company at a discount of 15%. A common variant is that your company will purchase the shares at the lower of the two price points, e.g. whichever price is lower on 1st January or 30th June will be purchased
  • You can then sell straight away or hold on to the shares.

The above is a typical example but there are a couple of variations out there, so consult your own employer for details.

Why the E.S.P.P. is a great idea

It's only when you start to crunch the numbers that you begin to see how rewarding an Employee Share Purchase Plan can be. Initially people might not be too impressed with a 15% return on an investment. You should be, when banks are only offering pathetic interest rates on deposit at best!

Lets take an example where the company buys the lower of the two price points:

The stock is $40 on the 1st of January but has slipped back to $35.29 by the 30th of June. 

As the stock went down, the company buy the stock at the lower price of $35.29

This is done at the discount rate of 15% so $35.29 * 85% = $30

You, for arguments sake, contributed $500 per month over the six months; 6 * $500 = $3000

That means you get 3000 / 30 = 100 shares of the company.

You sell your one hundred shares at the current market price; 100 * $35.29 = $3529

This means that by participating in the E.S.P.P. you have earned $3529 - $3000 = $529 in profit.

In terms of percentage you have earned (529 / 3000) * 100 = 17.63%

Think about that for a second, by putting you money aside for a six months you made an amazing 17.63% return for zero risk. I don't know about you, but if any one of my investments made a return of 17% over the the course of just six months I'd dance a little jig!

Another point to note is that the above happened when the shares went down, the percentages get even better if the stock does absolutely nothing in the six month period and get superb when the stock goes up.

This all assumes that you sell the shares straight away once you get them, which is the basis of all the above calculations. 

Tax considerations

Depending on your personal taxation circumstances, an E.S.P.P. can involve some work. That said, if someone offered you a guaranteed return of 7% to 10% (depending on your employers discount & taxation rate) in these days of low rate interest rates, why would you turn it down?

For a U.S. tax payer, shares obtained through an E.S.P.P. will be classified as either qualified or not qualified, depending on when the employee sells the shares. If the position is sold two years after the offering date and at least one year after the purchase date, the shares will fall under a qualified disposition. If the shares are sold within two years of the offering date or within one year after the purchase date the disposition will not be qualified.[1] These positions will have different tax implications, so seek relevant tax guidance.

For those in different countries, the tax implications are different, but if your company offers an E.S.P.P. scheme, your H.R. department should at the very least provide a starting point in investigating what to do. 

 

If the above taxation issues seem too much, you can always do what some of my colleagues without the forbearance to get through the tax headaches did. Use the E.S.P.P. as a temporary savings account for their Summer and Christmas Holidays and pull out of the E.S.P.P. at the last possible contribution window. This meant that they were saving a percentage of their income and getting a lump sum around the holidays, which suited them just fine. This is only an option for those of you who have a real difficulty saving as it is enforced saving and you get none of the potential interest you could get with a bank.

The dangers

Torn dollar

So far so good, an E.S.P.P. seems like a great idea, right? There is a saying: "Don't put all your eggs in one basket" and it comes into play here. Never have an amount of money you are not prepared to lose immediately invested in the company you work in. This is a form of double jeopardy as if your employer goes belly up, kicks the bucket, or whatever euphemism take your fancy, you have now lost your job and whatever savings were in your E.S.P.P. as the shares might now be worthless too. Examples include Enron and WorldCom of why this is a really bad idea, and I'd bet those very same employees said it could never happen to them or their employer.

Best practice is to sell the shares the day they are bought by your company, locking in the discount of 15% ( or 17.63% ) they give you and then using the funds as you see fit. At this point I will throw in a self learned lesson.  My first time participating in an E.S.P.P. was the 1st of July to 31st December window and guess where this author was on the 1st of January? Not selling his E.S.P.P. shares! The shares promptly fell in value and I had to wait around for the shares to return to their previous value before I could sell. Doing the right thing and selling as soon as possible does make the shares a non qualified position from a tax point of view but it is better to lock in the profits.

At this point I will put a disclaimer: I'm not a financial consultant or advisor, this is my own opinion not financial advice. Make your own decisions based on research and critical analysis when it comes to financial affairs, especially when it comes to stocks and shares. 

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Bibliography

  1. "Employee Stock Purchase Plan." http://en.wikipedia.org/wiki/Employee_stock_purchase_plan. 30/01/2013 <Web >

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