Employee Stock Purchase Plans

“Psssst! Hey, Buddy.”

You turn and spot a furtive looking character, trench coat drawn up around his neck, motioning you from the alley.

“What do you want,” you ask timorously.

“I don't want nothin’. I just want to make you some money. A lotta money. Fast.”

Mama warned you about guys like this, but you're still intrigued enough to stop—under the streetlight.

“Yeah, how much?”

He sidles up to you, “60% per annum minimum return, absolutely guaranteed. And maybe, if this job turns out good, a whole bunch more.”

If someone offers you a guaranteed 60% annualized return on your investment, and maybe a whole bunch more, run like hell, unless he’s got ESPP emblazoned on the front of his fedora. In which case, buy the gentleman a cup of coffee. He’s about to make you rich.

Free money

It’s not too often that the “gummint” of the USA joins with the Corporations to shower us with money, but the Employee Stock Purchase Plan program represents just such a conspiracy.

In a world where people usually make 3% to 10% on their investments, 60% would appear to be a deal so good it seems unbelievable that anyone would turn it down, but people do. And given the incomplete and confusing information that many corporation put out on the ESPP program, it is little wonder.

How it works

A typical ESPP program lets employees elect to set aside 10% of their salary to purchase shares of stock in their own company. This stock is typically issued at six month intervals. The purchase price per share is typically the market price of the stock less a 15% discount. The market price chosen is either the price at the beginning of the six month interval or the price at the end of the interval, whichever one is most favorable to the employee.

So employees are absolutely guaranteed to make 15% on their money.

“But you just said I’d make 60%!”

60% per annum (year). There’s a difference. The company didn’t keep your money for a whole year. The company didn’t even keep your money for six months, even though at first blush it might seem so.

How six months is really three months

On January 1st, you gave the company 10% of your paycheck, an amount they would keep for six months. On June 30th, you also gave your company 10% of your paycheck, but they didn’t keep it six months, they kept it one day. On average, then, they only had your money three months, holding half your money for longer than three months and half for less than three months. So you got 15% return on money that, in effect, was only in their grubby little paws for an average of three months.

That is a guaranteed rate of return of 60% per year. There is no other investment that comes even reasonably close to that kind of guaranteed return that does not involve the risk of being shot either by your general partner or a law enforcement officer.

How 60% can turn out to be chicken feed

Not happy with a measly 60% return? Try working for an upwardly mobile company.

Remember that the price of the stock is the lower either of the starting price or the ending price, depending on which is most advantageous to you. So let’s say that instead of that stock just holding its own, it really is growing. At the beginning of the period, perhaps the stock was worth, oh, I don’t know, maybe $8. Now, it is worth $50. However, you aren’t buying it for $50, less the 15% discount, you’re buying it for $8, less the 15% discount, or $6.80. However, you sure can sell it for the $50, including your profit of $43.20!

Now we’re talkin’ real money. Instead of a crummy 60% annualized return, you’re lookin’ at a return of $562% for three months, or an annualized return of over 2500%!

It can get even better

Just in case employees weren’t going to make enough of a killing on this deal, companies often throw in a couple of extra incentives.

First, some particularly generous companies allow you to set aside up to 15% of your salary toward the program.

Second, some companies don’t just limit you to the stock price on the first or last day of the six month period. They may also set a base price that could last 18 months to two years into the future. A stock—particularly a high-tech stock—can rise a whole bunch in 18 months to two years, so a scenario as outlined above become a lot more likely.

If it falls, so what? You’ll still make that guaranteed 15% (60% annualized), and that is still a killer investment.

Some companies also offer a three month period, instead of the usual six months. That effectively doubles the annual return on your money. In the case above, employees would make more than 5000% on their money.

When Good Companies do Really, Really Bad Things

A few companies in trouble have been known to turn ESPP programs into money-losers for their employees, so you must exercise a certain level of caution.

Typically, ESPP programs issue the stock on the day the pay out is made, at the end of every three- or six-month period. And they allow you to sell the stock on that very day ("same-day sales"). However, some companies, usually those in trouble, may play games, either taking a couple weeks to getting around to issuing the stock or applying a black-out period to employee stock sales that just happens to cover the period in question.

If you cannot sell your stock on the very day the payout is made, you lose any guarantee that, should the stock go down, you will not lose money. If your company is not doing well, you should have a copy, in writing, of their policy when it comes to same-day sales, and that policy should state that:

1. Stock certificates are issued on the pay-out date.
2. You may sell those certificates on the pay-out date without restriction.

If the value of your stock is lower at the end of the period than it was at the beginning, if you cannot exercise and sell on the day of the payout, you could end up losing not only your 15% profit, but part of your principle as well.

Fortunately, most ESPP plans allow you to "bail out" at any point in the process, receiving your money back, so you needn't panic early. Just exercise caution and get your hands on the written policy.

Bottom Line

ESPP is free money. Particularly when I work for a company whose stock has risen or is rising, I take out every penny I can, even if I have to borrow the money to get by at home. Particularly since I know won’t have to borrow it for that long a time. After the first six month period, you get the first of your winnings—I mean shares—and you can turn around and sell them immediately to pay off any loans and provide you with the capital to live comfortably during the next period.

If your company is slowly sinking beneath the waves, by all means exercise caution, as deliniated above. If, however, your stock is rising, and rising rapidly, as in the earlier example, that 10% or 15% you set aside can have a high enough return to effectively double your salary. When your employer wants desperately to give you a 100% raise, why turn them down? Make ‘em happy. Get rich.