There are many great articles explaining how Employee Stock Purchase Programs work, but this post focuses on how to evaluate your ESPP and set a strategy, if the opportunity is right.
We are going to break down the process into five simple steps:
- Identify key elements
- Calculate estimated return
- Evaluate if participating is worthwhile
- How to pay for your ESPP
- Analyzing when to sell or hold
Identify Key Elements
All ESPP’s were not created equal. The discount rates, favorable tax dates, offering periods, and other key figures can vary. To be able to understand your plan, you will want to find and document the following information:
Allowed Contribution Percentage: The ESPP will only allow a percentage of your annual pre-tax salary to be used, and the IRS will only allow $25,000 to be put in an ESPP. You will have to use the smaller of the two numbers.
Discount Percentage: The discount percentage varies by plan. This is the guaranteed discount at which stock will be purchased. Many programs include a “look back” provision that allows the plan to use the offering date or purchase date stock price and take the lower of the two before applying the discount. We will only use the discount percentage for our calculation as that is what is guaranteed.
Offering Period: Also known as the duration from the time that money starts being deducted from your payroll to the purchase date. This will help us calculate our return later.
Holding Period for Favorable Tax Treatment: In the plan documents, there will be information on how long you must hold the stock from the offering date to receive capital gains treatment. For most ESPPs, it is going to be 2 years, but this can vary. This will come into play as we analyze the risk of holding the company stock.
Calculate Estimated Return
We recommend evaluating all investment opportunities through an annualized tax-adjusted lens. The ESPP is no different. It is important to note that what we are about to calculate will be a close estimate of the return of selling on the purchase date, because stock prices fluctuate by the second.
As a baseline, you should start with the “worst case” return that would be received if you were to sell right after the shares were granted on the purchase date. This is the worst case, because technically there could be additional appreciation during the offering if the plan uses a lookback. You can calculate using the three steps below:
Step 1: Discount rate / (1 – Discount rate) = Pre-tax return
Step 2: Pre-tax return / (Offering period (months) / 12 months) = Annualized pre-tax return
Step 3: (Annualized pre-tax return) / (1 – Ordinary income tax rate) = Annualized tax-adjusted return
Here is an example for an employee who is in the 24% tax bracket, works for a company that has a 15% guaranteed discount, and a 6 month offering period. Let’s assume this employee were to sell on the purchase date:
Step 1: .15 / (1-.15) = 17.6% Pre-tax return
Step 2: .176 / (6/12) = 35.2% Annualized pre-tax return
Step 3: .352 * (1-.24) = 26.7% Annualized tax-adjusted return
Evaluating if Participating is Worthwhile
Based on the number that you calculated above, is the sale on purchase date estimate attractive enough for you to participate? In the vast majority of instances it will make sense to not only participate, but to participate to the maximum amount allowed. But it's always good to evaluate other opportunities available to you and decide if you could make a better return elsewhere.
How to pay for your ESPP
According to recent studies, only 1 out of 3 employees eligible to participate in their Employee Stock Purchase Plan do so. Furthermore, even a lower percentage maximize the allowed benefit. One common reason for not participating is lack of excess cash flow.
If your cash flow may be an issue if participating, an alternative is to look into financing options designed specifically for ESPP's: local credit union ESPP programs affiliated with your company, RootedLending, Lendtable, and employer sponsored ESPP financing (this one is very rare).
Analyze When to Sell or Hold
Before the purchase date you will want to decide whether to sell the ESPP stock on the purchase date, or if you would rather hold to capture additional appreciation or favorable tax treatment. Considerations include:
- How volatile is my company stock?
- What is the growth trajectory of my company stock?
- Do I have other stock that will be vesting/already vested, and will the ESPP cause me to have a large concentration in my company stock?
- Does the livelihood of my company influence other assets I own?
If you are financing the ESPP, holding past the purchase date does bring on added risk that needs to be taken into consideration. If you are holding for favorable tax treatment, consider the volatility and the uncertainty of where the stock may be after the holding period to receive favorable tax treatment. You can then determine if it is worth the risk vs. a more certain return at a less favorable tax treatment. If you have a large percentage of your assets tied to your company, you will also want to think through the pros and cons of holding additional company stock, especially if you are financing the ESPP contribution.
ESPP’s can be a great way to capture additional value through your company. There are many ways to participate, and financing can be a great option if your cash flow is tight. Lastly, it is important to note that your risk increases if you don’t sell your position on the purchase date.
If you have any further questions, don’t hesitate to contact the Sage Wealth Planning team via LinkedIn, Facebook, or the contact form below.