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For my company (large international software firm) I am allowed to buy company stock at a discounted price. To me all I see are pros such as:

  1. Being able to sell the stock right as I buy it, increasing my earning.
  2. Even if the stock price falls a bit, I would still be increasing my earning (but the outlook on the stock prices looks pretty good).

What are some cons (or some pros that I missed) for these kind of purchases?

This is ESPP and in the US (more specifically, CA)

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I would make sure you understand the rules of the ESPP because they can be different for each company for things like selling period, etc –  Madmanta Aug 15 at 18:54

6 Answers 6

up vote 10 down vote accepted

Is this an employee stock purchase plan (ESPP)? If so, and there is no required holding period, selling right away is essentially a guaranteed bonus with minimal risk. One caveat is that sometimes it takes a while to actually receive the shares at your brokerage, and in the meantime your company may have an earnings report that could cause the share price to drop. If your discount is only 5%, for example, a bad earnings report could easily wipe that out.

The only other cons I can think of is ESPP contributions being withheld from you for months (albeit for a virtually guaranteed return), and it complicates your taxes a bit.

On the flip side, another pro is that after you sell the shares, you are more likely to invest that money rather than spend it.

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Sometimes takes a while to actually receive the shares is a very important caveat. I worked at a company that issued paper certificates for each buy. It took 30 days from the buy until I was in a position to sell, which was too much risk exposure for a 15% discount. I don't always sell shares immediately, but I want to have the option. –  Ben Jackson Aug 15 at 22:44
    
@BenJackson paper stock certificates? What year is this??? –  Craig W Aug 15 at 23:05
    
@BenJackson you could have bought puts, in theory –  CQM Aug 16 at 5:24
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@CQM Most companies won't let you buy put options on the company's stock! –  Chris Taylor Aug 16 at 17:14
    
@ChrisTaylor actually if you look at the financials for large companies you will find they sell a lot of puts. Adds revenue for the company and if exercised it is effectively a stock buy-back. –  Michael Aug 16 at 20:05

The major pros tend to be:

  • The X% discount on whatever you put into the program

The major cons tend to be:

  • You typically can't withdraw the money that you've contributed until the stock is bought. In all the ESPPs I've had, the plan will buy stock twice a year.
  • There may be delays between the stock purchase, when you can sell it, and when the money is available to transfer to another account. (Sometimes the process takes 1-2 weeks for everything to settle in the plans I've worked with)
  • The discount complicates your taxes a bit. The way I understand it, the "X% discount" is usually considered income. All of my employers have paid the federal tax on this, but you need to check your paystub and the plan details.
  • Depending on when you decide to sell, the increase/decrease in value may confuse the tax situation a bit more. Any increase in the stock price after it is purchased but before you sell can either be income or capital gains depending on the plan and/or how long you hold.

Being in California, you've got state income tax to worry about as well. It might be worth using some of that extra cash to hire someone who knows what they're doing to handle your taxes the first year, at least.

I've always maxed mine out, because it's always seemed like a solid way to make a few extra dollars. If you can live without the money in your regular paycheck, it's always seemed that the rewards outweighed the risks.

I've also always immediately sold the stock, since I usually feel like being employed at the company is enough "eggs in that basket" without holding investments in the same company.

(NB: I've participated in several of these ESPP programs at large international US-based software companies, so this is from my personal experience. You should carefully review the terms of your ESPP before signing up, and I'm a software engineer and not a financial advisor.)

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I asked about tax withholding on ESPPs here. My employer didn't end up withholding taxes on the discount, but it's such a small amount it didn't matter much. –  Craig W Aug 16 at 1:39
    
Do check the tax implications. The plan my company offers has a "strike price or current price, whichever is cheaper" formula -- nice, but it forced us to treat every purchase as a separate offering. That meant a lot of number juggling when we wanted to sell those shares. It turned out that the personal-finance package I was using could actually handle this, but I had to work through the whole thing manually before I was convinced that I could trust it. My conclusion was that it was worth the effort for the original 15% discount, too much hassle for the current 5%. –  keshlam Aug 22 at 0:48

Some other answers mention the ability to sell at grant. This is very important. If you have that ability, think about your guaranteed return.

In my case, I get a 15% discount on the lowest 6 month window price from the last two years. If you do the math, the worst case return can be calculated:

1) Money that from the beginning of the window, I make 15% for 6 months (30% annual return guaranteed)

2) Money at the end of the window (say the last month) is 15% for one month (180% annual return guaranteed)

In the end, your average holding window for your money is about 3 months (you can calculate it exactly). At that rate, you have a guaranteed 60% annual return. You can't beat that anywhere, with a significant upside if your company stock is increasing. So, if your company has an instant sell at grant option, you have to be brain dead not to do it. If it takes time to get your shares, then you need to look at the volatility of the stock to see how big the chance of losing money is.

To generalize to a formula (if that's what you want):

WM = purchase window (in months); D = Discount Percentage; GR = Guaranteed Return

GR = 12/(WM/2) * D = 6*D/WM

One last thing, If you are going to participate in ESPP, make you that you understand how to do your taxes yourself. I haven't found a tax person yet who does ESPP correctly (including an ex IRS agent), so I always have to do my taxes myself to make sure they get done correctly.

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Good points. The average 3 months out of pocket is right. The return is 100/85 or 17.6%. How you treat the compounding is up to you, since there's no option to be invested for the full year. –  JoeTaxpayer Aug 16 at 17:43

Assuming US.

The only con that I know of is that hassle factor. You have to remember to sell when you get the new shares, and your taxes become a bit more complicated; the discount that you receive is taxed as ordinary income, and then any change in the price of the stock between when you receive it and you sell it will be considered a capital gain or loss. It's not hard to account for properly if you keep good records.

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One major benefit to being able to buy discounted company stock is that you can sell in-the-money covered calls and potentially make more than you would selling at strike.

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I see another way of looking at this that hasn't been addressed yet.

By offering the discount, the company is attempting to change your behavior into doing something irrational, that benefits them at your expense.

The company hopes for one (or more) of the following psychological effects to happen to you:

  • You'll allow the stock to become a large amount of your portfolio, adding more risk for no additional return.
  • You'll delay selling the stock even when it would be ideal to do so.
  • You'll feel like you and the company are on the same side (loyalty), causing you to work harder/longer and find ways to save the company money / bring in more profit.

The proper thing to do, if you have enough capital to prevent margin calls, it to short-sell the stock at the same instant the price is set, thus locking in the profit. Eventually you can take possession of the shares and deliver them to offset the short -- hopefully before you get a margin call from the stock dropping.

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Most companies won't let you short the company's stock... –  Chris Taylor Aug 16 at 17:16
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@Chris How is that communicated and enforced? Is it part of the employment agreement? Do you have to give them the passwords to all your brokerage accounts, or do the brokerages report who's short directly to the company? Do they also prohibit synthetic shorts like going long a put and short a call? –  Snowbody Aug 17 at 3:24
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In every publicly traded company I've worked for, it's been part of the employment agreement. To what degree it's enforced, I don't know, but certainly if the company ever round out you would lose your job (and possibly face legal action). The phrasing generally prohibits you short selling, or taking a position which is equivalent or gives you similar exposure, so synthetic shorts would be disallowed, as would any derivative position which benefits you if the company's stock drops. –  Chris Taylor Aug 17 at 8:27
    
In the case of the one publicly traded US company I've worked for (a large software firm), the restriction on options was even simpler than that: you will not hold anything other than shares. No puts, no calls, no nothing. –  Philip Kendall Aug 17 at 18:54
    
@Chris thanks for the info; I only worked for one publicly traded company and it was through a placement firm; we didn't have an employment agreement but we were allowed to participate in the ESPP (no discount though so it was worthless). –  Snowbody Aug 17 at 21:57

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