An Employee Stock Purchase Plan (or Program) is an interesting form of compensation offered by some companies which allows participants to purchase company stock at a discount to market price.
A common purchase discount for an ESPP is 15% of the market value on the either of two days: The first day money is locked up (known as the 'lookback' date) of a 6-month period, and the last day of the cycle. Two 6-month cycles make up the average ESPP, and each cycle locks up your money for the entirety of that period.
How does that translate to the bottom line?
Say a person is making $100,000 a year - $90,000 in base pay and $10,000 in bonuses. They can contribute up to 10%, or $10,000 into the ESPP.
Base Pay: $90,000
Bonus Pay: $10,000
ESPP Contribution: -$10,000
Net Cash (Pre-Tax) $90,000
Say the price of stock on the 20th is $20.00 a share:
If the price stays steady until February:
588 shares purchased, market value $11,760
If the price declines to $15.00 a share:
784 Shares purchased, market value $11,760
If the price increases to $25.00 a share:
588 shares purchased, market value $14,700
Total salary: $101,760, $101,760, $104,700. This person effectively got 1.76% (or even 4.7%) raise, just by participating... not too shabby.
Can you lose money in an Employee Stock Purchase Plan?
Of course... everything in investing has risk. Two specific scenarios stick out in the risk consideration:
1) Your employer can go bankrupt while holding shares (especially during the 'float' between the grant and the shares being available to sell, referenced below). Reference Arthur Andersen, MCI Worldcom, Enron, Bear Sterns, Countrywide Financial etcetera for stories of what happens in that case. Yes, you now have bigger problems than stock losses.
2) If you decide to hold your shares, the stock price can continue to decrease AFTER the stock is purchased. Of course, you are continuing to purchase every 6 months, so your exposure is cut by the fact you are averaging down. If you sell immediately, you can avoid this to a degree.
What does a declining stock price mean?
Basically, a declinging stock price means more shares for you in an employee stock purchase plan.
Of course, you can sell immediately and take out all the risk to lock in a 15% profit. Or, alternatively, you can let it ride (and infinite other combinations). However, may I suggest selling immediately?
A key thing to consider in holding onto your ESPP shares is single company risk... if you work at a company that isn't doing well, not only are your savings (in the form of ESPP granted company stock) at risk, but so is your very employment. You should practice diversification... sell immediately and invest your money elsewhere. However, if you think that you would invest in your company assuming you had free reign to pick to invest anywhere... then by all means, leave your stock in the account.
Full tax advantages of holding onto ESPP shares take two years to take effect. Any sales before two years are considered a 'disqualifying distribution', and the difference between the price you paid and the fair market value on the purchase date is considered income. The difference between the price at the time of sale and the cost basis (market value on the purchase date) will be treated as normal capital gains or losses.
You can see more in my ESPP tax and return calculator.
There is one case where a large amount of damage can be done. As detailed at this site, if the price of the stock increases greatly between the lookback date and the final date, that difference will have to be reported as income regardless of the selling price! If you end up selling the shares for less than the lookback date's value, you will owe tax on the income you WOULD have earned had you sold immediately. In this case, ensure you hold onto your shares for two years.
Second, 15% is the discount on the date of the stock grant. Between the date of the grant and the shares actually hitting your brokerage account, lots of things can happen. The stock price can go down, (or even to zero, theoretically) up, and stay flat. This has to be considered in any discussion of ESPPs.
More Math on the ESPP...
A 15% discount translates into a 17.6% gain, just for participating (1 / .85). However, your actual gain and annualized gains are much better than that.
Say you get paid every week, and $100 goes into your ESPP:
$100 * 26 = $2600
Your shares are worth $3058.82, for a gain of $458.82. On the surface, you made ~17.6%. However, look closer. You made 17.6% on a 6 month lockup of your money.... but your money (because of the timing of your paychecks) was only locked up for an average of 3 months. Annualized, this works out to a ~ 90% annualized gain! (1 * (1.176^4))
That's tough... or impossible... to beat with ANY investment. Also, this is the minimum (other than the 'float' discussed above) that you can possibly earn. An employee stock purchase plan can feel like a money printing press.
Conclusion: Sign up for the ESPP Today!
The only real downfall to the program is your money is locked up for 6 months. In 6 months this money will be free to leave in your brokerage or sell, and the next participation period won't affect you (since the current period's money will be available). It really will only affect you the first 6 months... so get it over with. You can either sell at that point, or leave it in, but either way you've given yourself a raise.
My suggestion? For the vast majority of employers you should max out your employee stock purchase plan... and sell immediately. It's not worth the uncertainty of waiting for favorable tax treatment, where a small decline can wipe out any gains you got from waiting for the lower tax rates. So, sign up, max out, and invest your gains elsewhere! Happy investing!