Do you work for a public company that offers an employee stock purchase plan (ESPP)? If you answered yes, this note is for you.
If your employer offers an ESPP, you should probably contribute as much as you can afford, up to the maximum amount allowed by the plan. I’ll explain.
1. What is it?
An ESPP allows employees to purchase company stock at a discount of at least 15%. Typically, participants contribute funds through payroll deductions over a 3- or 6-month period and then automatically purchase the stock at the end of the period.
2. What makes it special?
The purchase price for the ESPP stock is generally set to a 15% discount of the lower of the market prices on the first and last day of the purchase period. An example should help:
- Assume that on the first day of the purchase period, the stock price was $100.
- The stock went up and 6 months later (on the final day of the purchase period), the stock price was $120.
- You get to buy the stock at a price of $85 (15% off of $100), creating an immediate gain of 41%.
- However, if the stock price had collapsed and was $50 on the final day of the purchase period, no worries. You would buy the stock at a price of $42.50, creating an immediate gain of 17+%.
The worst case scenario is that you lock in a 17% gain for no effort and no risk. Such a deal is hard to find.
3. What’s the catch?
Usually none. Most plans allow you to immediately sell the stock at the end of the period and I recommend you do that every time, thus locking in your gain.
However, some plans impose a holding period of some time before you can sell it. This is unfortunate because it forces you to take on the risk that the stock price will decline and you’ll lose your gain.
4. Should you participate?
Most ESPPs allow for an immediate sale and in those cases, you should contribute the maximum the plan allows and sell the stock immediately. This is the best deal around so don’t let it pass you by. It’s so good that an entrepreneur started a company to lend employees money to participate.
However, if your plan does not allow you to immediately sell by imposing a holding period, I advise more caution about participating in the ESPP, subject to how long a delay it imposes on selling the stock. You’re taking a risk that you’ll lose money instead of a guaranteed gain and if the holding period is a long time, that risk can be significant.