What it means
An employee chooses how much of their pay to put into the plan, usually a percentage of salary. The money is deducted after each pay period and held until the purchase date.
On that date, the plan uses the accumulated money to buy shares for the employee. The discount is the main attraction.
In many plans, particularly those qualified under US tax rules, the discount can be up to 15% of the market price. Some plans also use a lookback, which means the purchase price is based on the lower of the price at the start and the price at the end of the offering period.
Because the shares are bought at a discount, there is often an immediate gain if the employee sells right away. Employees can choose to hold the shares, though this concentrates their money in the employer: if the company has trouble, both their job and their savings are affected.
Many advisers suggest selling at least part and diversifying. Companies use these plans to build loyalty and align staff interests with shareholders.
The cost to the company is the discount and the administration, and the accounting expense is based on the benefit given. The plan also raises a modest amount of capital through new shares or share purchases in the market.
Tax rules differ from country to country, and between qualified and non-qualified plans. In some systems, holding the shares for a minimum period leads to better tax treatment of the gain.
Employees should read the plan documents and seek advice rather than assuming the rules are the same everywhere.
In practice
Real-world examples.
Example
A marketing manager puts 5% of her monthly pay into her employer's ESPP. After six months, the plan buys shares at a 15% discount. She sells half the shares straight away to pay for a holiday and keeps the rest.
Example
A software company offers an ESPP with a lookback feature. The share price rises sharply during the offering period, so employees buy at a price based on the lower starting price. The plan produces a large gain for those who participate.
Example
A junior accountant joins a company with an ESPP but chooses not to take part because she needs all her pay for rent. Her colleague contributes the maximum and benefits from the discount. The company reminds staff that participation is voluntary.
Formula
Calculation
Purchase price = Market price x (1 - Discount)
Shares bought = Contributions / Purchase price
Worked example: An employee contributes $6,800 over the offering period. The shares trade at $40 on the purchase date, and the plan offers a 15% discount.
Purchase price = $40 x (1 - 0.15) = $34
Shares bought = $6,800 / $34 = 200 shares
Market value = 200 x $40 = $8,000
The immediate gain is $8,000 - $6,800 = $1,200, which is before any tax.Case study
Seen in the real world.
Crestview Retail is an illustrative, fictional chain with 800 employees that launched an ESPP with a 10% discount. At first, only 15% of staff joined, because many thought the plan was only for managers.
HR ran short sessions explaining how it worked, using a simple example of a $200 monthly contribution. Within a year, participation rose to 40%, and employees reported feeling more connected to the company's results. They also invited a financial planner to answer questions.
In this illustrative story, the share price fell 25% in the second year, and some employees who had held their shares saw their savings drop. The company then added guidance encouraging staff to sell part of their shares and diversify. The case shows both the appeal and the risk of owning employer stock.
Watch out
Common mistakes.
- Holding all shares in the employer, when job and savings are then exposed to the same company's fortunes. A common rule of thumb is to sell enough to keep any one stock to a modest part of total savings.
- Forgetting tax, when the discount and any gain can be taxed, and the rules depend on the plan and holding period. Keeping records of purchase dates and prices makes the tax return easier.
- Putting in more than you can afford, when money in the plan is not available until the purchase date. Emergency savings should be set aside before joining a plan.
Questions
People also ask.
What is a lookback?
It is a feature that sets the purchase price using the lower of the share price at the start or end of the offering period. It can make the effective discount much larger when the share price rises during the period.
Is an ESPP the same as a stock option?
No, an ESPP buys shares directly at a discount using payroll deductions, while an option gives a right to buy at a fixed price later. The ESPP is usually less risky for the employee because the shares are bought at a discount, not a gamble on future price.
Can I leave the plan?
Most plans allow employees to stop contributing and get their money back before the purchase date, but the rules differ. Check the dates, as contributions made before a cut-off may be locked in.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%Related