The Risks of Employee Stock Purchase Programs

Correction: An earlier version of this piece incorrectly stated you’d pay short-term capital gains taxes on the spread between your discounted option price and the fair market value of the stock. It has been corrected below to clarify you’d pay ordinary income tax, not short-term capital gains taxes (as you have no capital gains, if you flip the share immediately). Fortunately, for all practical intents and purposes, these are the same number (your marginal tax rate), lest my error. Depending on the way your plan is structured and the strike price you’re offered, you may also owe short-term capital gains taxes as well on the spread.

So your company is offering you discounted access to company stock. What do you do?

(Pssst…for our full deep dive on all things stock-based compensation, check out this week’s episode of The Money with Katie Show!)

We only sprinkled a little bit of podcast fairy dust on ye ole’ Employee Stock Purchase Program (ESPPs) on the show this week, so I wanted to talk about my take on ESPPs in more #depth here.

ESPPs are generally treated as part of your paycheck elections (that is, you can opt to buy discounted stock with your income instead of taking it as income).

Some employers will pay you with stock as part of your compensation package (and this becomes increasingly popular as you move up in a company), but we’re not talking about receiving stock as compensation here—we’re talking about the option to buy it at a discount.

It’s important to consider the potential pitfalls of any investment decision, especially when it comes in the form of HR paperwork and well-intentioned Janice from payroll encouraging you to “get that 10% discount on the stock!”

According to Human Capital, 85.5% of information technology companies and 68.3% of healthcare companies in the S&P 500 offer ESPPs to their employees. In the Russell 3000, 67.7% of IT companies and 60.2% of healthcare companies provide ESPPs. In other words, if you work for a large public company, the chances are good you’ll have some version of this option available to you—but there are many different ways to structure such a perk.

There are effectively two ways to use your ESPP: One is like walking through the front door, and the other is like using the revolving door in the back.

First, let’s break down the risks of “walking through the front door”—using the ESPP as a buy-and-hold strategy.

The main risk? Compromising diversification of your investment portfolio

You know how I’m always harping about how one of the best ways to protect yourself in down markets is to be properly diversified?

When you participate in an employee stock purchase program, you’re trading diversification for cheaper access to a particular asset. Usually, the discount is somewhere between 5%–15%.

As we’re all probably well aware by now, as a general rule, I don’t believe in buying any individual stocks as a major component of my investing strategy. 

A 2021 JP Morgan study examining the loss probability of individual stocks found that 42% of stocks in the Russell 3000 had negative absolute returns between 1980 and 2020 and 66% trailed the index as a whole (which is a fancy way of saying, 6 in 10 individual stocks that made up the index actually underperformed the average of the 10 overall). All that to say: You have worse than a coin flip’s chance in working for a company with a stock that beats the index over the long run.

And while it’s certainly possible, it’s—statistically speaking—not overly likely in the long term.

Now, I always used to caveat this speech by saying, “That is, unless you work for, like, Facebook!”

…except for the fact that—this year—the stock’s meteoric gains were almost totally wiped out after the company placed a huge bet on the metaverse, and was down 65% by the end of the year. 

The other issue at hand? If you work for one of the biggest tech companies and own a bunch of S&P 500 or Total Stock Market index funds, you already own a disproportionate amount of your own company’s stock. Apple alone comprises 6.3% of the S&P 500 index fund.

And while you can make the case that Apple and Google are going to continue their climb to world domination, if history is any indication, most big companies are eventually usurped. Owning too much of any one company—no matter how dominant it seems today—isn’t the safest plan if your investing strategy is intended to carry you through the next few decades.

One counterargument I’ve often heard is, “But if I’m working for this company and have an impact every single day on its success, isn’t that worth betting on?”

…and I think that point stands if you work in a four-person startup.

If you’re working for a company that’s already large enough to be publicly traded, it’s unlikely that your contributions as one individual are going to have any real bearing on what the stock price does or the long-term success or failure of the company (unless you’re the CEO or another exec; in which case, would you like to sponsor Money with Katie?).

There’s one other risk associated with holding too much of your company stock:

The secondary risk: Your income and investments are tied up in one company’s success

While this doesn’t really apply if your company stock accounts for a tiny fraction of your total portfolio (which may be a bet you’re willing to make), if you’re primarily investing in company stock and taking your paycheck from that same company, you’re relying on the same hen for all your financial eggs. (How’s that for a twist on the “eggs in one basket” analogy?)

The same point goes for the big tech employees—your company is already disproportionately represented in your index funds, so you’re placing an even bigger bet when you load up on more.

After all, “diversification” means owning assets that aren’t perfectly correlated—and it doesn’t get much more correlated than big tech and the S&P 500.

If something happens to your company, not only do you lose your paycheck, but that portion of your portfolio suffers, too. (Enron employees have entered the chat.)

Regardless of who you work for or how great they seem, that risk may not be worth taking.

Of course, most people who use an employee stock purchase program aren’t only investing in their own company stock—but I’ve definitely seen young new hires sign up for the program in an attempt to be a well-intentioned Budding Adult™ and not bother to invest anywhere else.

In that way, their entire financial future is tied up in the success or failure of one company. It’s too risky.

But what about using the revolving side door? That’s another story.

How to hack your ESPP for a guaranteed return

All of that proselytizing out of the way: Depending on how your ESPP is structured, it might be a way to get some guaranteed returns on your money. 

Let’s take a walk down benefits planning lane, shall we? If your plan…

• Provides a discount on the stock

• Accumulates your cash contributions over a defined “accumulation period” or “offering period” (call it 6–12 months) and then buys the discounted shares of your company stock on the purchase date

• AND allows you to sell immediately (with reasonable trading costs) without restrictions or blackout dates, with bonus points if your ESPP allows you to automate the sale…

…then you may be in a good position to take advantage of this revolving side door. 

By allocating a portion of your income to a plan like this, you’ll “guarantee” a 15% return on your investment (minus ordinary income tax). Some companies will even honor the lowest price of the stock over the offering period on the purchase date, so it’s possible you’ll capture even more upside—it’s worthwhile to dig into the details of how your plan is set up.

For example, if your company stock costs $10 per share and you get a 15% discount, your company would accumulate your cash contributions during each pay period over the length of the offering period, then buy shares for $8.50/each on the purchase date. If you were to place a sell order immediately, you’d earn $1.50 profit per share, on which you’d pay ordinary income tax come tax season.

That’s a 17% return on investment ($1.50 earned on $8.50 invested), with a marginal tax rate-sized #chonk taken out for your ordinary income taxes. If you’re in the 24% bracket, for example, you’d earn $1.14 in net profit on each $8.50 invested—a 13% real return on investment, on up to $25,000 worth of pre-discounted stock per calendar year. 

Of course, you have to weigh this priority with your other financial priorities (for example, contributing to a 401(k), an HSA, a Roth IRA, etc.), but if you’re in a position where you’ve checked those boxes and you’re looking for other #optimizations to make, it might be worth exploring whether or not your employer stock purchase program is structured in a way that would make this possible.

It sounds like a lot of back and forth, but if your company allows you to automate your contributions and sales, it may be well worthwhile (and an automatic savings device, like your 401(k), which is valuable in and of itself because it takes indecision and forgetfulness out of the equation).

Before making any big moves,

Consult a tax professional. Per the disclaimer on this website, I am not a licensed financial professional—just a gal who loves to invest, learn about the tax code, and share what I find.