Employee Stock Purchase Plan (ESPP) Basics
An Employee Stock Purchase Plan (ESPP) is a tool that tech companies offer to employees to help them purchase company stock.
Companies often offer employees discounts on the products their company sells. (Nike, for example, offers 40-50% off of their gear to its employees.)
ESPPs work just like an employee discount on company products -- except, instead of a discount on clothing or some other product, the discount is applied to the purchase of company stock.
So rather than getting a pair of Nike running shoes for $60 instead of $100, you’re able to buy company stock for $85 to $90 instead of $100.
At this point you might be thinking, “Umm, that seems like a better deal over at Nike! I’d rather get a discount on Nike gear and take a pass on the company stock.” Hopefully, by the end of this article we’ll convince you that the far better choice is to make use of your ESPP option rather than purchase the latest Nike Free Runs.
ESPP Enrollment & Offering Period
Companies will let employees join the ESPP at the beginning of what’s called an Offering Period. An offering period can be last as long as 27 months but the most common length of time is either 12 months or 24 months.
Once you enroll in the ESPP, you’ll be eligible to participate in the upcoming offering period and will be able to purchase company shares at a discount for the length of that offering period. After that period is over, you’ll be able to rejoin the ESPP under a new offering period.
Let’s say you started working at Adobe in November 2023, but their next offering period doesn’t begin until January 2024. You should receive emails from HR (or some other benefits team) at Adobe asking if you’d like to enroll in the ESPP at the next available offering period. If you say yes, you’ll be enrolled as of January 2024 and you’ll be able to participate in that offering period through the end of 2025.
ESPP Purchase Period
Within each offering period is another section of time in which you set aside money to purchase company stock at a discount. This section of time is known as the Purchase Period. The length of the purchase period can vary, but usually they are 6-month windows in which you save a certain money out of each paycheck to purchase stock.
At the end of the 6 months, the money that has been set aside will be used to purchase company stock at a discount. Then the process will repeat again and you’ll be able to purchase company stock in another 6 months.
ESPP Purchase Date
The Purchase Date is the date on which you officially purchase company stock. This happens at the end of the purchase period, not during.
This can be confusing for people that are new to ESPPs because throughout each purchase period, money is being pulled from your paycheck. Even though this money is being pulled from your paycheck, it’s being held until the purchase date which is at the very end of the purchase period.
Offering Period & Purchase Period Example (24 months with 6 month purchase windows)
Here’s an example of how the offering period, purchase periods, and purchase dates might line up.
ESPP Discount
Normally to purchase stock you have to set up an account at a place that allows you to purchase stock, like Robinhood, E*TRADE, Charles Schwab, Vanguard, etc., and from there you can purchase your company stock for whatever it is currently trading for.
Through an ESPP, you’re able to get a discount of up to 15%. (The discount can vary based on the company.)
Again, let’s say you work at Adobe (ADBE is the ticker symbol) and it’s trading for $600 a share at the end of your purchase period.
If Adobe offers a 15% discount through its ESPP, this will mean you can purchase shares of Adobe for $510 each instead of $600! You can then sell them or hold them for better tax treatment (more on that later). Overall, it’s a pretty awesome deal and has the potential to be even better.
ESPP Lookback
On top of the discount your company may give you, it’s possible your company will offer a Lookback.
Rather than purchasing stock for the current market price every 6 months, a Lookback provision will choose the better of two prices for you. You will be eligible to purchase at the cheaper of the two:
(1) the date of purchase
Or
(2) the date at the beginning of the offering period.
Here’s a quick example:
Adobe on 7/1/2020 was valued/trading at $440 a share and on 12/31/2020 was valued at $500 a share.
Since Adobe has a Lookback provision and offers a 15% discount, employees who participated in the company ESPP were able to get a discount based on the value from 7/1/2020 instead of 12/31/2020. This means that employees could purchase shares for $375 a share instead of the latest market value of $500 a share! So for every share you purchase, you’re making a free $125.
What’s even crazier, is that the price of $440 will stay valid until the full offering period has expired. Meaning that even if the price continues to move upwards, employees participating will be able to keep purchasing for the discounted price of $375 a share no matter how much the stock price increases.
We’ll provide more examples later in this article that will illustrate how much money can be made by utilizing an ESPP properly.
ESPP Limits
There are two main limits that affect what you’re able to contribute to an ESPP.
$25,000 is the maximum that can be contributed to an ESPP in a given year.
This $25,000 is based on your company’s market value on the first day of the offering period.
This means that if your company is trading for $100 on 1/1/2024 (the beginning of your offering period), the maximum amount of shares you’ll be able to purchase is 250. So if in 12 months the company is trading for $100 still and you get a 15% discount, $25,000 could technically get you 294 shares, but due to the restriction based on the value at the beginning of the offering period, the maximum amount of shares you can purchase will be 250 instead.
Employers will limit your contributions to some maximum percent of your salary. This can be a range of percentages, but typically we see between 15% to 90%. Adobe, for example, will limit their employees to 25% of their salary.
There are other factors and more specific details to these limits, but a lot of finance blogs get even these two limits wrong. The $25,000 limit may seem like a big drawback, but even with that limit in place, you’ll still come out ahead.
ESPP Disposition Types
Shares that have been purchased through an ESPP will have two ways they can be disposed of. (1) A Qualified Disposition and (2) a Disqualified Disposition.
ESPP Qualified Disposition
An ESPP Qualified Disposition is defined as a sale of ESPP shares that meet the following requirements:
2+ years have passed since the beginning of the offering period in which you purchased shares
1+ year has passed since the purchase date of the shares
ESPP Disqualified Disposition
An ESPP Disqualified Disposition occurs anytime one of the two rules from a qualified disposition aren’t met.
The benefit of doing a Qualified Disposition instead of a Disqualifying Disposition is that you will pay less in taxes if the price has steadily increased. There are some scenarios where it’s actually better to complete a Disqualifying Disposition, but you won’t have to learn about that now.
The important thing to know is that a Disqualified Disposition may sound scary, but it can actually provide you a lot of benefit, especially if you purchased shares for a discount.
ESPP Scenarios (Worst Case, Average Case, and Best Case)
As you can see, there’s not a lot of risk from participating in your ESPP. If you want to model out your own ESPP, we’ve built an ESPP Gain and Tax Calculator to help make it easier.
Our Recommendations
Assuming you don’t have any high interest-bearing debt and assuming you can afford to, we recommend maxing out your ESPP. Even if you’re a little tight on cash, you can quickly sell the shares you purchase for a profit and use the proceeds as needed. There are also companies out there like Lendtable and HeyBenny that help employees fully participate in their ESPPs.
We’ll publish another article soon discussing how to weigh the pros of contributing to an ESPP vs 401(k). Ideally you’re able to maximize both of these vehicles, but if you can’t you should put some into both.
Other Notes
The taxation on ESPPs can get complicated and tracking it properly can be tedious if you’re using TurboTax or other solo tax prep software. Be sure to consult with a financial or tax professional (CFP or CPA) for help as needed.
Each tech company is different in how they choose to offer ESPPs to their employees. Some will have fine print on the lookback provision if you change around your contribution percentage. Be sure to read all of that information and use what you learned here to make sure you’re executing an effective strategy.
Please reach out with any questions you have or requests for additional information covering this topic.