If your company offers an Employee Stock Purchase Plan (ESPP) with a discount provision… pay attention. With certain provisions, an ESPP can be a fantastic investment vehicle for growing long-term wealth. 

What is it?

An ESPP allows you to purchase shares of your employer’s stock, typically at a discount to market value.

How does it work?

You elect to participate in the ESPP during the plan’s enrollment period. Companies will usually allow you to contribute up to 15% of your salary per year (up to a $25,000 maximum).

When the purchase period begins, your employer will withhold your chosen percentage from your paycheck via a payroll deduction. This money will be set aside as cash during the purchase period. After a specific period of time (eg 6 months), the plan will purchase company shares in your account. The shares will stay in your account until you decide to sell them.

Cool.. Why should I care?

Many companies offer a 15% discount with a look-back provision. When the plan purchases company stock at the end of the purchase period, it buys shares at the lower of:

1) today’s price minus 15%

2) the price at the beginning of the purchase period minus 15%

Let’s assume your ESPP plan has a 6-month purchase period with a look-back provision, and today is the end of the purchase period. If the stock price went down during the purchase period, the company will buy shares at a 15% discount to today’s stock price. If the stock price went up during the purchase period, the company will buy shares at a 15% discount to the price 6 months ago (resulting in a larger gain).

If you sell the shares immediately after the shares are purchased by the plan, you’ve earned a positive return in either scenario with virtually no risk. This is a big deal. There are very few investment vehicles that offer such a high return for such a low level of risk (an employer match on a 401(k) contribution has a similar risk/return profile).

Let’s look at a detailed example:

• Your salary is $100,000 annually
• You decide to contribute 10% of your salary into the ESPP starting January 14th (bi-weekly pay schedule).
• You contribute $384.62 every 2 weeks for 6 months via payroll deductions. After this 6-month draw period, your ESPP account accumulates $5000 in cash.
• On July 1st (stock purchase date), your company’s stock is trading at $100 per share.
• On January 1st (6-month look-back date) the company’s stock was trading at $120 per share
• The company purchases shares at the lower $100 price per share minus 15% = $85/share. The plan purchases 58.82 shares in your account ($5000 cash/$85 purchase price). 
• You immediately sell the 58.82 shares on the open market for $100 per share for total gross sales proceeds of $5882.
• You’ve just earned a $882 return (before taxes) on an initial investment of $5000, resulting in a 17.65% return  

How does the ESPP compare to other investments? 

17.65% is NOT the annualized rate of return earned on the ESPP plan contributions. In our example, you had 13 separate deposits of $384.62 (every 2 weeks for 6 months), therefore you had 13 different holding periods.

We need to annualize this rate of return using an XIRR calculation in Excel to compare it to other investment options. The results yield a stunning 98% annualized rate of return if the company’s stock price goes down. The annualized return is much higher if the stock price appreciates during the holding period. As a comparison, the annualized rate of return of the S&P 500 from 1926-2017 is 10.2%.

If you’re curious about the numbers, Harry Sit (aka “The Finance Buff”) goes into detail in his blog post, Employee Stock Purchase Plan (ESPP) Is A Fantastic Deal. Adam Nash (former CEO of Wealthfront) expanded on Harry’s calculations in his blog post Your Employee Stock Purchase Plan (ESPP) is Worth a Lot More Than 15%.

The ESPP plan can be a powerful tool. Many plans contain specific features, or do not include a discount provision. Therefore each plan should be evaluated on its own. All that said… please do me a favor… DO NOT IGNORE YOUR ESPP!