How Does your Employee Stock Purchase Plan (ESPP) Work? A Simple Explanation:
Updated: Jan 20
So, you just got hired at a company and a couple months in, you receive an email about "ESPP enrollment". This article will help you understand Employee Stock Purchase Plans (ESPPs) and give you a better understanding of how they work.
What is an ESPP:
Employee Stock Purchase Plans (ESPPs) are a type of employee benefit that allows workers to purchase company stock at a discounted price. These plans can be a valuable source of additional income for employees and can also help align their financial interests with those of the company.
ESPPs typically operate on a discounted purchase price model, where employees can buy company stock at a price that is lower than the current market value. The discount is usually between 5% and 15%.
For example, if the current market value of a company's stock is $100 per share and the ESPP offers a 10% discount, employees would be able to purchase shares for $90 each.
Some plans even offer beneficial terms such as a discount on the lowest price of either the starting or ending price during the ESPP period. For example, your ESPP lasts 6 months and the starting price of the stock is $150, but the stock goes down to $100, you would get the stock at $90, almost ensuring a profit.
It's important to note that you should educate yourself on how your company's ESPP is set up to make sure you understand the terms. Your benefits team should have detailed information on this. ESPPs are typically funded through payroll deductions, with employees choosing to contribute a certain percentage of their salary towards stock purchases. The funds are then used to buy stock at the discounted price during a predetermined purchase period.
Benefits of an ESPP:
One of the main benefits of ESPPs is the opportunity to purchase company stock at a discounted price. This can be a great way for employees to potentially earn a higher return on their investment if the stock appreciates in value over time or if they get a discount of the lower prices, ensuring a profit. ESPPs can also be a useful way for employees to diversify their investment portfolio, as they can use the discounted stock to add to their existing investments or to create a new position.
Drawbacks of an ESPP:
There are a few potential drawbacks to participating in an ESPP. One concern is the risk that the stock may not appreciate in value, which could lead to a loss if you continue to hold the stock. Another potential drawback is the impact on an employee's cash flow. Payroll deductions for an ESPP can reduce the amount of take-home pay available for other expenses, which could be a concern for some. Finally, it's worth noting that ESPPs may have tax implications. In the United States, for example, the discounted portion of the stock purchase may be considered income and subject to ordinary income tax.
Should I Invest In an ESPP:
If you're considering participating in an ESPP, here are a few tips to keep in mind:
Understand the terms and conditions of the plan, including the discount rate, purchase period, and any vesting requirements. Certain plans almost guarantee a profit, so this is a huge thing to make sure you understand.
Consider the financial health and prospects of the company before deciding to participate.
Determine how much you can comfortably contribute through payroll deductions without affecting your cash flow.
Consider the potential tax implications and how they may impact your financial situation.
Use the discounted stock as an opportunity to diversify your investment portfolio.
Overall, Employee Stock Purchase Plans can be a valuable benefit for employees looking to invest in the company they work for. By understanding how the plans work and carefully considering the potential benefits and drawbacks, you can make an informed decision about whether participating in an ESPP is right for you.
I (David) personally max out my ESPP every year as for me it is a great way to generate additional income over a 6-month period. Always feel free to reach out to us if you want to discuss the options and help form a plan in the contact section above.