ESPPs Offer Special Benefits In Down And Volatile Markets

When stock prices fall, the topic of underwater stock options tends to rise. Companies have well-established choices for handling employee stock option grants in which the market price of the company’s stock is cheaper than the option exercise price, temporarily making the options worthless. But how do falling stock prices affect other forms of equity compensation?

Employee stock purchase plans (ESPPs) function a lot like stock options in that you are purchasing your company’s shares, typically at a discount. However, there are key differences in their dynamics when the stock price declines. This article explains what you need to know for participating in your company’s ESPP with a falling or volatile stock price.

The Good News: ESPPs Can’t Go Underwater

ESPPs cannot be underwater in the traditional sense of having a purchase price greater than the current stock price. With an ESPP, the market price of the stock at the beginning of an offering does not completely control your actual purchase price, unlike with stock options, where the exercise (purchase) price is the market price at the time of grant.

In fact, ESPPs with a discount and a lookback provision for calculating it can be a good deal even in a down market. This is because you get to take the discount off either the start-date price or the purchase-date price, whichever is lower. If you do not have a lookback, you still get a discount off the market price on the purchase date.

Example: The stock price at the start of the offering is $14. The price on the purchase date is $10. The 10% discount is applied to the lower purchase-date stock price, resulting in a $9 purchase price. By contrast, if you had stock options that were granted with a $14 exercise price, a stock price of $10 would make the options underwater.

Volatility Does Not Always Matter

With most ESPPs, what matters is the stock price at the start of the offering period and on the purchase date. A big drop in the stock price during the offering period that mostly recovers before the purchase date does not affect your purchase price.

Example: Your company’s stock price is $14 on January 2, when the offering period starts. It falls to $9 by late March due to the impacts of the Covid-19 pandemic. On the purchase date six months after the offering start (July 2), the stock price has recovered to $13. The ESPP discount in the purchase price is taken off the $13 stock price on July 2.

The Bad News: Limits On The Amount Of Stock You Can Purchase

When your company’s stock price falls, you may not be able to purchase as many shares as you would like at the lower price. It depends on the amount of your payroll contribution (e.g. 10% of your salary).

With a tax-qualified Section 423 ESPP, under IRS rules you are allowed to purchase up to $25,000 worth of stock in a calendar year, though your company can set a lower limit. (For details about the $25,000 limit and how it works, see the related FAQ at the website myStockOptions.com.)

The value of your stock for this $25,000 limit depends on the stock’s undiscounted price when the offering begins, not at the purchase date. Let’s say your purchase discount is 10%, the stock price on the offering date is $20, and the stock price on the purchase date is $10. You can buy up to 1,250 shares ($25,000 divided by $20), not 2,778 shares ($25,000 divided by $9 purchase price). This can mean that your company refunds any amount contributed from your salary for an ESPP purchase over $11,250 (1,250 shares at $9 per share). However, if your payroll contribution for your ESPP is usually $11,250 or less, the lower share price does allow you to buy more shares than you would be able to if the price rose during the purchase period.

Special Plan Features In Down Markets

When its stock price falls by the purchase date, your company may have a rollover provision. During a long offering period (e.g. 24 months) with a six-month purchase period, a rollover automatically withdraws you and then re-enrolls you. This lets you take advantage of the lower lookback price, both for the $25,000 calculation and for when the market rises (hopefully) during the full offering period. This restart feature may be automatic or at the discretion of your company.

Alternatively, your company may have an automatic reset. This type of provision is also triggered when the market value on the purchase date is lower than it was at the enrollment date. The lower price on the purchase date is reset to become the lookback price (no new offering period started).

ESPP Benefits Are Worth The Complexity

For a detailed look at ESPP dynamics and tax treatments with a falling share price when you sell the ESPP stock, see the article Fundamentals Of Employee Stock Purchase Plans (Part 4): Down Markets And Other Tax Topics at myStockOptions.com.

As explained by The Great Benefits Of Your Company’s Employee Stock Purchase Plan, in any market conditions you should take full advantage of your company’s employee stock purchase plan. ESPPs offer an easy, efficient, painless, and rewarding way to pursue a disciplined savings plan and build your financial resources for the long term.