Decoding Equity Instruments: Employee Stock Purchase Plan 

An ESPP, or employee stock purchase plan, is a program initiated by a company to enable its employees to buy its stock at a lower cost. This reduced price is often around 5-15% less than the stock's market value when purchased.

ESPPs function by permitting employees to set aside a specific portion of their earnings during each pay cycle, which is subsequently used to invest in the employer's stock. As the designated period concludes, the company buys shares on behalf of the employees at the discounted rate. In simpler words, instead of buying their company's stock outright, employees who take part in the program contribute to their plan via automated deductions from their paychecks.

How does ESPP work?

The Employee Stock Purchase Plan operates selectively; not every employee is eligible. Employers evaluate a group of employees, picking those who have shown strong and consistent performance, with a likelihood of continued dedication to the company. They decide the numbers, considering exercise prices, qualified employees, and the allotment of options per individual.

Once the calculations are finalized, the company usually waits for the stock to reach a 52-week high. Then, details about the discounted options are shared. Employees then buy stocks at this reduced price. When employees decide to invest, the company starts deducting the necessary funds from their monthly salaries. This deduction happens from the grant date until the allotment date. Once the required amount is deducted, employees start to own these allotted shares.  

Employees who own more than 5% of the company’s stock are not eligible to participate in ESPP. On the other hand, those with less than specific years of employment – 1 or 2 years, depending on the company- are not eligible for participation. Notably, ESPP is a benefit scheme and there is no compulsion that employees to participate.

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Related article: ESPP vs ESOP: Differences Between Equity Linked Compensation Structures

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Advantages of ESPP

• Discounted stock purchase: ESPPs typically offer employees a discount of 5-15% on the fair market value of the company's stock.
   
• Potential for capital gains: If the stock price of the company increases, employees can sell their shares for a profit. The amount of profit will depend on the size of the discount and the increase in the stock price.
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• Participation in company success: ESPPs allow employees to participate in the success of the company. If the company does well, the stock price is likely to increase, which means that employees can make a profit on their investment.
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• Tax benefits: In some cases, employees may be able to defer taxes on the discount on ESPP shares until they sell the shares. This can save money on taxes.

Disadvantages of ESPP

• Stock price volatility: The stock market is volatile, and there is no guarantee that the stock price of the company will increase. If the stock price decreases, employees could lose money on their investment.
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• Vesting period: In some cases, employees may have to wait for a vesting period before they can sell the shares, they purchase through an ESPP. This means that employees may not be able to access their money if they need it in the short term.
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• Taxes: Employees may have to pay taxes on the discount on ESPP shares, even if they do not sell the shares immediately.  

Difference Between ESOP and ESPP

• ESOP: An employee stock ownership plan (ESOP) is a qualified retirement plan that allows employees to acquire shares of their company's stock through a trust. The company contributes shares of stock to the trust, and the employees then purchase shares from the trust at a discounted price. ESOPs are typically used by privately held companies.
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• ESPP: An employee stock purchase plan (ESPP) is a non-qualified retirement plan that allows employees to purchase shares of their company's stock at a discounted price. Employees contribute a portion of their paycheck to the plan, and the company then purchases shares of stock for the employees at a discounted price. ESPPs are typically used by publicly traded companies.

Bottom Line

Employee stock purchase plans (ESPPs) allow employees to buy shares of their company's stock at a discounted price, typically 5-15%. Employees contribute money from their paychecks to the plan, and the company then purchases the shares for the employees at a discounted price.