If you work for an employer that offers an employee stock purchase plan (ESPP), then congratulations: These plans can be an incredibly valuable benefit, and it's absolutely worth your time to look into your plan and consider enrolling.
Your first step should be to familiarize yourself with the basics on what an ESPP is and how it works. Next, you'll want to look into some of the key features of your employer's plan, such as:
- Discount rate. Most, but not all, ESPPs let employees buy shares at a discount. The most common discount is 15%, but some plans offer 5% or 10%. Other plans may offer a match instead of a discount.
- Lookback provision. Plans with a lookback calculate the price you pay for each share based on the stock price on the first day or the last day of the offering period—whichever is lower. A lookback feature generally adds more value when the stock price is rising.
- Number of purchase periods per year. This determines how often shares are purchased and deposited into your account.
Once you have a grasp on those basics, consider digging into some of the finer points of your ESPP, such as the tax implications when selling your shares, if any company restrictions would impact your ability to sell shares, and what happens if you need your money before the purchase date.
3 potential sources of returns
To understand the potential value of your ESPP, it can be helpful to separate the 3 key ways an ESPP plan can potentially generate a return:
- Discount rate. Any discount offers a built-in source of return—like an employer match on 401(k) contributions. Suppose your plan offers a 15% discount, and on the purchase date your company's shares trade for $100. You would only pay $85 per share, and you would receive shares worth $100. If you sold your shares, you would realize that $15-per-share gain, before accounting for taxes. (If you hold the shares, the stock price may fluctuate and when you sell, your realized return could be higher or lower than $15 per share.)
- Lookback provision. A lookback provision has the potential to add to returns. How much it might add will vary with the stock's performance. Suppose that over the purchase period, your company's stock rises in price from $100 per share to $110 per share. With a lookback, you pay the lower of those 2 prices. Even without a discount, you would pay $100 for shares worth $110. With a 15% discount, you would pay only $85 for shares worth $110. (And if, by contrast, the stock price declined over the purchase period, such as from $100 to $90, you would still get the lower of the 2 prices—paying $90 per share if you had no discount, and only $76.50 per share if your plan had a 15% discount.)
- Stock price performance. As mentioned above, if your plan offers a lookback provision then you can benefit from an increase in share price over the purchase period. And if you hold onto your company's shares after purchase and they rise in price, then this will also add to your returns. Of course, it's never guaranteed that the value of your shares will go up. Changes in the stock price could increase or reduce your returns.
How much potential return might it add up to?
ESPP plans that offer a discount can provide powerful potential for cash generation over shorter-term periods. Consider how a hypothetical employee participating in their company's ESPP could fare after just 1 year of participation. In the example below, we've assumed that an employee has contributed $5,000 to their plan, over 2 purchase periods, and that their plan offers a 15% discount and a lookback. This example also assumes the stock has risen by 10% over the year.
Again, these figures are hypothetical, and further, they don't reflect the tax impact of selling the shares. But they do hint at how the availability of a discount—or even a discount in combination with a lookback provision—can potentially generate cash over a year or less, which employees may then use to put toward other goals.
Harnessing an ESPP over the longer term
While the short-term cash-generating potential of an ESPP can be powerful, so can the potential for longer-term returns, for those interested in a more sophisticated and hands-on strategy.
Consider our earlier example, and imagine that this person is now going into their second year of participating in their ESPP. Further, suppose that instead of simply contributing $5,000 again, they choose to stack a new $5,000 contribution on top of the $6,169 proceeds that they earned the previous year—contributing $11,169 for the year. This strategy can potentially allow the returns from the discount and the lookback to compound. And over time, those compounded potential returns could really add up.
Modeling can never fully capture the nuances of the real world or perfectly predict its ups and downs, but it can give a sense of the potential range of outcomes. We modeled a hypothetical employee's potential returns over 10 years, if they added $5,000 a year to their ESPP savings strategy—again assuming that the plan offers a 15% discount rate and a lookback, and making certain assumptions about the stock's long-term performance and volatility. We also made certain assumptions about how much of the stock the employee holds, versus how much they sell and reinvest in a diversified portfolio.
| Potential wealth after 10 years | |||
|---|---|---|---|
| Contributions: | Outcome at 25th percentile: | Median outcome: | Outcome at 75th percentile: |
| $50,000 | $84,598 | $106,954 | $140,239 |
Figures are hypothetical and for illustrative purposes only. See footnote 1 for more details on assumptions used.
While the potential outcomes may be impressive, there are also real-world complexities to keep in mind if considering such a long-term ESPP strategy. Since all contributions must come from your paycheck, it's not possible to simply roll a previous period's ESPP proceeds forward into a new period. Instead, the person would need to increase their contributions from their paycheck each period—so, for example, contributing more than $11,000 from their paycheck in the second year (and even more the following year, and so on). And there is an annual purchase limit of $25,000 that applies to stock purchases within an ESPP, which participants would need to be aware of and plan around.
Is participating in your ESPP worth it?
For many people, participating in their company's ESPP will indeed turn out to be worth it. That's because the great majority of plans do offer a discount, and many additionally offer a lookback. As we saw above, the presence of those features means participating can help to generate cash over shorter-term periods such as 1 year or less, and potentially even help generate competitive longer-term returns, for those interested in a more hands-on strategy.
Should you participate in your ESPP?
Of course, just knowing that your ESPP might hypothetically be "worth it" doesn't necessarily mean that participating is right in your situation. For many people, it makes sense to first check a few other boxes off of their financial to-do lists—like building some emergency savings, fully capturing any employer match of retirement savings, and paying off any credit card debt.
But once you're standing on a solid financial foundation, participating in an ESPP that offers a discount can potentially be a powerful tool to help generate cash and grow your money.