Conventional wisdom holds that it’s dangerous to tie too much of your personal wealth to your employer’s fortunes. Why? Because if your company falls on hard times, any shares of company stock you own will take a hit and, to make matters worse, you could have your salary cut or lose your job.
When it comes to employee stock purchase plans (ESPPs), conventional wisdom about not putting too many eggs in one basket may be worth reconsidering. According to the National Center for Employee Ownership, millions of employees are “leaving money on the table” by not participating and taking advantage of “money that is in plain sight” through an ESPP.
So What is an ESPP?
Many large U.S. corporations offer ESPPs, in which most employees can buy their company stock through payroll deductions. Most ESPP’s allow you to buy shares of your company’s common stock at a discount from its current fair market value. Discounts typically range from 5% to as high as 15%. And who does not like a discount?
In addition, many companies offer a “look-back” feature that allows you to buy the stock on either the first or the last day of the offering period, whichever day offers the lowest price. And who does not like a lower price?
ESPPs in Action
To understand why an ESPP may make sense for you, consider the hypothetical case of Fred, who works for Acme Incorporated. Fred enrolls in Acme’s ESPP, which offers a 15% discount and a six-month look-back provision. On the offer day, Acme’s stock is trading at $20 a share. At the end of the six-month offer period, the stock now trades at $22 a share.
Thanks to the look-back provision, Fred can buy the stock at $20, rather than the current price of $22. And thanks to the 15% employee discount, Fred only pays 85% of the purchase price, which in this case would be $17. If Fred sells his shares immediately at $22, that’s a tidy pretax profit of 29%.
Of course, there’s no guarantee a company’s stock price will rise during or after the offering period. Even if the stock price declines during the offering period, the employee discount alone has the potential to provide an attractive return.
If, in the example above, Acme’s stock declined to $18 at the end of the offering period, Fred could decline the look-back option and buy the stock at a 15% discount or $15.30. If he sells immediately at $18, he’ll still earn a gross return of 17.6%.
In each of these examples Fred made a nice profit. He will almost always profit with a 15% discount when he sells his shares immediately. So, are you leaving money on the table? He may also earn a profit by purchasing at a lower price as shown in the first example. Do you see money that is in plain sight?
Considering the Risks
Before enrolling in your company’s ESPP, first consider how much cash you can afford to use towards stock purchases. Only use excess cash that you do not need for living expenses or to pay off debt.
Make sure you check out your company’s financial health by requesting the latest annual report and financial statements before enrolling in your ESPP. Decide to enroll in your ESPP only if your company has healthy financial statements and prospects.
If you receive incentive stock options or restricted stock awards, or own company stock in your 401(k) plan, you already have a good amount of your personal wealth in your employer’s stock. Remember when you participate in an ESPP, you do increase your concentration risk.
Consider minimizing your overall risk by selling your shares immediately. However, if you are willing to hold the stock, there is a prolonged risk the stock might fall below your purchase price by the time you are ready to sell it.
Key ESPP considerations are the discount amount, whether there is a look-back provision and the purchase period. And unlike investments in your 401(k) plan, capital gains from ESPP transactions are not tax-deferred. If your company offers an ESPP, talk to your tax advisor to first see if it makes sense to participate before you take action, and second, to assist you with your taxes.
If you would like additional information or have questions, please contact Larry Ruff at [email protected] or call him at 312.670.7444.