October 7, 2020
By Rahul Iyer
Employee Stock Purchase Plans (ESPP) are company run programs that allow participating employees to purchase company stock at a discount rate. Simply put, these plans give you (as the employee) the right to buy company stock using money deducted from your paycheck, without any commission on the purchase, and often at a discounted price.
There are often key features of ESPPs, and you should try to familiarize yourself with these. The plan usually has an offering period and purchase date. The offering period is when the post-tax salary deductions occur (when the money is taken from your paycheck). The purchase date is when the deducted money is used to buy company stock. The offering period differs between companies and specific plans but is usually 12 to 18 months long. At the end of the offering period, the company will use the accrued funds to buy stock on your behalf (purchase date). However, if your company has an offering period of 12 months, this doesn't necessarily mean that you only purchase company stock every 12 months. Companies often establish interim purchase periods every six months.
You're probably familiar with how company matches work for retirement plans, but if you're not, you can read more about it here (link). It works similarly for stock plans. Some companies will match your contributions dollar for dollar. For example, if you contribute $300 of your paycheck each month, your employer will also contribute $300. Not every company will match this way; some may opt for 50%. It's also common for the match to trail off the more you invest in the plan since the company will only match up to a certain percentage.
Lookback provision is often the part of ESPP that many people struggle to understand, but if you strip away the legal-speak and convoluted examples, it's straightforward.
This is what you need to know about lookback provision:
During the purchase period (when the company will purchase stock), employees are guaranteed the lowest stock price. For example, let's say that the stock price is $22 at the start of the purchase period and $27 at the end of the purchase period. The ESPP will purchase the stock at $22 for you.
Most ESPPs stipulate that individuals who own more than 5% of company stock cannot participate.
You will typically contribute anywhere from 1% to 10% of your salary.
Your contribution is calculated on your pre-tax salary but is taken post-tax. Unlike 401(k) plans, there is no deduction on ESPP contributions.
ESPPs are categorized as either qualified or non-qualified.
Qualified plans are the most common type and have specific characteristics. Before they are implemented, they are approved by a shareholders vote. They cannot exceed 27 months. The discount on stock price is capped at 15%. Under this plan, all participants have equal rights.
Nonqualified plans are simpler and don't have the same rules as qualified plans. This article deals with qualified plans only.