An employee stock purchase plan (ESPP) buys company stock for participants at set intervals, usually every six months. An ESPP can be a very good deal. Employees at companies with ESPP purchases during the stock-market lows of March and April 2020 experienced meaningful gains of over 40% in the market rebound as of mid-June, according to data from a major brokerage firm.
How ESPPs Work
The features of ESPPs include:
- after-tax contribution from your pay
- a set offering period when payroll deductions occur
- set purchase dates that use the accumulated deductions
- typically a discount on the stock-purchase price
While there are various kinds of ESPPs, the most common type is known as a Section 423 plan, named after the part of the tax code that provides rules for it and the favorable taxation of the purchase discount.
Some ESPPs have a lookback provision for calculating the purchase price. This very beneficial feature bases the purchase price for calculating the discount on the stock price either at the beginning of the offering period or at the end of the purchase period, whichever is lower.
Unique Benefits Of ESPPs
What’s unique about an ESPP, compared with stock options (which are similar), is that the market price of the stock at the beginning of an offering does not control your actual purchase price. With stock options the exercise (purchase) price is the market price at the time of grant regardless of whether the stock price has fallen or risen since grant.
Another special aspect of ESPPs is that eligibility is usually companywide for employees at all levels. By contrast, at many public companies stock options and restricted stock units are granted only to certain employees and executives. Under the IRS rules for Section 423 ESPP plans, companies can exclude workers only for very specific reasons, such as being employed for less than two years. With broad-based participation, ESPPs can thus perhaps even play a small rule in reducing income inequality, including the racial wealth gap.
Discount Plus Lookback Provide The Best Deal
As I explained in my recent Forbes.com blog ESPPs Offer Special Benefits In Down And Volatile Markets, ESPPs with a discount and a lookback feature are a good deal even in a down market. This discount calculation would come off of the lower purchase date price, even without a lookback.
Your company uses a 15% discount with a six-month lookback.
- The offering date price is $10.
- The stock market price on the purchase date is $8.
- Your purchase price is $6.80 (85% of $8, not 85% of 10).
- In the price-drop example, your initial gain is 17.64% ($1.20 spread at purchase divided by $6.80 purchase price), before any change in the stock price after purchase
Data Shows Big Gains For Employees With Purchases In Down Markets
With most ESPPs, you can withdraw from an offering or decrease your salary contribution percentage. Once the impact of Covid-19 hit the economy, it may have been tempting for employees to pull out of their ESPPs and use the money for immediate needs.
However, data provided to me by Fidelity Investments shows the wisdom of sticking with your company’s ESPP. In March and April, many companies experienced major declines in revenues and stock prices, but so far the stock markets have since rebounded remarkably. According to Fidelity’s data, employees with ESPP purchase dates when stock prices were low have realized substantial gains in the rebound. This shows that ESPPs can be an effective and disciplined from of investing at regular intervals, similar to dollar-cost averaging. (Disclaimer: Fidelity is a client of my company. It did not pay in any way for mention in this article.)
Breakdown Of ESPP Data From Fidelity
Of the Section 423 ESPPs that Fidelity Stock Plan Services manages for companies of varying sizes and industries, 48% of them had purchase dates for employees in March or April 2020, during the big stock-market decline. Fidelity looked at Section 423 plans with a 15% purchase price discount, both with or without a lookback, and quarterly or semiannual purchases that occurred in those months (i.e. purchase date every 3 or 6 months during the ESPP offering).
Fidelity found that, of those with lookback features, 32% of the companies used the offering-date stock price for the purchase-price calculation (i.e. stock price was still higher on purchase date), while 68% used for the calculation the lower price on the purchase date. Return on investment (ROI) for these employees in Section 423 ESPPs:
- All but two companies had positive ROI for employees as of June 17. At three companies, the price declined from the purchase-date stock price but positive ROI was still generated for employees based on discounted purchase price.
- At almost 96% of the companies, the positive ROI for employees in the ESPPs spans from 10%+ to 100%+ as of June 17 for those that held their companies’ shares.
ESPPs Can “Democratize Wealth Accumulation”
For Emily Cervino, Head of Thought Leadership at Fidelity Stock Plan Services, the data tells a very encouraging story about the significant wealth-building potential ESPPs present for employees at all levels. ESPPs can provide employees with some insulation from stock-market volatility when they have certain design features, she explained to me. “Thanks to the ESPP discounts and the market recovery, most of our [plan] participants have had impressive gains in their March and April purchases,” she added. “For many companies, the ESPP has been a bright spot in an otherwise difficult time.”
Emily also commented on the bigger role that ESPPs can play in “democratizing wealth accumulation.” These plans are not about executive compensation, she emphasized, as ESPPs provide the same financial benefit “from the very top to the very bottom of the organization.” Plus, as the coronavirus pandemic reveals the wisdom of stockpiling emergency savings, it is crucial to note that ESPPs can help employees build savings faster—whether by selling the shares to bank the cash proceeds or holding shares that keep going up in price.
For more on employee stock purchase plans, including taxation and financial planning, see the ESPP section at myStockOptions.com, an independent educational resource on all forms of stock compensation, including stock options, restricted stock, restricted stock units, and ESPPs.