If you work for a publicly traded company which offers an Employee Stock Purchase Plan (ESPP), you’ve got yourself a fantastic deal. An ESPP typically works this way:

1. You contribute to the ESPP from 1% to 10% of your salary. The contribution is taken out from your paycheck. This is calculated on pre-tax salary but taken after tax (unlike 401k, no tax deduction on ESPP contributions).
2. At the end of a “purchase period,” usually every 6 months, the employer will purchase company stock for you using your contributions during the purchase period. You get a 15% discount on the purchase price. The employer takes the price of the company stock at the beginning of the purchase period and the price at the end of the purchase period, whichever is lower, and THEN gives you a 15% discount from that price.
3. You can sell the purchased stock right away or hold on to them longer for preferential tax treatment.

Your plan may work a little differently. Check with your employer for details.

The 15% discount is a big deal. It turns out to be a 90% annualized return or higher.

How so? Suppose the stock was $22 at the beginning of the purchase period and it went down to $20 at the end of the period 6 months later. Here’s what happens:

1. Because the stock went down, your purchase price will be 15% discount to the price at the end of the purchase period, which is $20 * 85% = $17/share.
2. Suppose you contributed $255 per paycheck twice a month. Over a 6-month period you contributed $255 * 12 = $3,060.
3. You will receive $3,060 / $17 = 180 shares. You sell 180 shares at $20/share and receive $20 * 180 = $3,600, earning a profit of $3,600 – $3,060 = $540.

Percentage-wise your return is $540 / $3,060 = 17.65%. But, because your $3,060 was contributed over a 6-month period, the first contribution was tied up for 6 months, and the last contribution was tied up for only a few days. On average your money is only tied up for 3 months. So, earning 17.65% risk free for tying up your money for 3 months is equivalent to earning (1 + 17.65%) ^ 4 – 1 = 91.6% a year.

90%+ a year return is fantastic, isn’t it? That’s when the employer’s stock went down. Had the stock gone up from $20 at the beginning of the purchase period to $22 at the end, your return will be even higher at 180%!

[Update on May 30, 2008]: I created an online spreadsheet on Zoho. You can plug in your own numbers and calculate the annualized return. The annualized return is what a savings account will have to offer in order to match the same return from an ESPP. Even at 5% discount without lookback, an ESPP is still equivalent to a 20% APY savings account.

What should you do if your employer offers an ESPP? Participate to the MAXIMUM allowed as long as you can sell the stock soon after the stock is purchased.

Should you hold the purchased stock longer for preferential tax treatment? No! On the typical 6-month purchase program, you will have to hold on to the stock for additional 18 months in order to get preferential tax treatment. If everything goes well, you can reduce the tax on your profit from say 35% to 15%. In the above example, that will save you $540 * 20% = $108. But if your employer’s stock goes down 3% during the 18 months you are holding the stock, because your entire $3,600 is at stake, the tax benefit will be completely wiped out. You already earned 90% annualized return on the purchase. Holding on for another 18 months and hoping the stock won’t go down 3% is really penny wise pound foolish.

More technical details about ESPP on the web:

• Designing and Implementing a Section 423 ESPP by Timothy J. Sparks of Wilson Sonsini Goodrich & Rosati
• Guide to Employee Stock Purchase Plans (ESPPs) by Kaye A. Thomas of Fairmark (I strongly disagree with Mr. Thomas about his objection to flipping ESPP shares. The risk of holding the stock is too high.)

---
Software picked, likely related articles at The Finance Buff:

• Imported Spreadsheets to Zoho
• Carnival of Personal Finance, 2nd Anniversary Edition
• Restricted Stock Units (RSU) Tax Withholding Choices