Suggested ESPP Strategies

This is a list of strategies that one can use to optimize expected returns from an employee stock purchase plan (ESPP).

1. Always Enroll

The only significant drawback to enrolling is that you defer the income from your contributions. The risk of actually losing money is negligible if you sell as soon as possible.

Diversification: The Only Free Lunch It is widely known that diversification reduces risk, because the likelihood of many securities all dropping in price is considerably less than the likelihood that a single security will drop in price. But if you are not risk averse, and are seeking only to maximize expected returns (for example, because your time horizon is very long), you might wonder why it's important to diversify. The answer is that if you are willing to assume the risk associated with a particular single security, then you can achieve a higher expected return at the same risk by investing in a diversified portfolio of many securities, each of which is riskier than your single security. This is because many investors have a limited horizon, and therefore the overall market is risk-averse, meaning that it demands a higher expected return from riskier securities. Similarly, you can achieve a lower degree of risk at the same rate of return by diversifying into various securities of similar risk as your company's stock. However, this argument is valid only to the extent that the market is perfectly efficient. If you actually know better than the market, then other considerations may prevail.

2. Contribute the Maximum

Assuming that you sell your shares as soon as possible and that the stock price is unlikely to change significantly between the purchase and the sale, then the expected annualized return is about 0.85 ^-4 - 1, or 91%. This represents a far more attractive risk/reward proposition than any investment available on the open market.

3. When in Doubt, Sell ASAP

1. You get to diversify your investment. (See sidebar: "Diversification: The Only Free Lunch.")
2. You are already over-invested in your company by virtue of being employed by it, and even more so if you have stock options on it.
3. Some plans provide for a "same-day sale" option which if elected guarantees that the purchase price does not exceed the sale price even if the stock price declines by more than 15% between the purchase and the sale, thereby completely eliminating the risk of losing money.

This is not to say that your company's stock couldn't possibly outperform the market by a wide margin, but when you average all the possible outcomes, it probably doesn't. If you could really predict what the stock price was going to do, then you wouldn't need to work for a living, right?

4. Hold if Stock is Undervalued

However, you should also be aware that there is no shortage of casual observers who believe that they can beat the market, and almost all of them are wrong, so you should try to avoid being one of them. Furthermore, it is in your employer's interest to paint the rosiest possible picture of its future, so you should exercise a certain degree of skepticism. On the other hand, markets can be fallible in the short term, and as an employee you probably know things that the market doesn't know. (Note that things you know might make it illegal for you to trade. See sidebar: "Are You an Insider?") Provided that you also know everything that the market knows and that you are willing to assume the risk associated with being over-invested in your employer, you might have good reason to hold after all.

But if the grant price is significantly greater than the exercise price, then instead of holding you should still sell ASAP and then re-purchase the shares on the open market. This maneuver will lead to a more favorable (i.e. lesser) capital basis in the event that the stock price does rise and the holding periods are met. It may trigger the wash sale rule, but it still avoids all of the special rules for ESPP taxation that are likely to work to your disadvantage in this case. There is no significant tax advantage in holding ESPP shares unless the exercise price exceeds the grant price.

Are You an Insider? Simply put, if you don't know that you are an insider, then you probably aren't one. The Securities Exchange Commission (SEC) defines an insider as a person in possession of "material non-public information" (a.k.a. "inside information"), and prohibits such persons from trading. However, inside information must also be specific and actionable, such as an unannounced business agreement or a serious undisclosed product defect. Knowing whether or not your management is competent may be considered both material and non-public in layman's terms, but it does not legally constitute inside information. If it did, then you might never be allowed to sell your stock at all. If you are a person such an executive who is perpetually in possession of inside information, then I assume that you understand your legal obligations to formally disclose your intent to trade. Otherwise, it's in your employer's interest to prevent you from obtaining inside information, or at least to make you aware of the legal nature of that information should you obtain it.

5. Hold if Exercise Price is Much Greater than Grant Price

However, by holding, you assume the considerable risk that the stock price may fall substantially by the time the holding periods are met. This is especially true after the first purchase period, when you must hold for 18 months (rather than 12) in order to meet the holding periods. Therefore, you should still sell ASAP if you think the stock is overvalued, or if there is significant risk that it will fall below the grant price by the time the holding periods are met.

A good way to assess the risk of the stock price falling below the grant price, assuming that the stock is fairly valued, is to consult the open options market. Find the trading price of a call option on your stock that expires when your holding periods are met, and with a strike price equal to the grant price. If the price of such an option is less than 110% of the difference between the exercise price and the grant price, then it's a pretty safe bet that your sale price after the holding periods are met will exceed the grant price.

6. Consider Withdrawing

Since the re-enrollment deadline is usually a couple of weeks prior to the beginning of the purchase period, by electing this option you risk that the stock prise will rise by then. Also, you forego the discount associated with the impending purchase. Nonetheless, this can be an attractive option, especially near the end of the second or third purchase period, if you think the stock is undervalued, and if you expect to remain eligible for participation in the ESPP for the entire new enrollment period.

You also might want to withdraw shortly before the first close of a purchase period in a calendar year if the stock price is much less than the grant price, in order to avoid the US IRC section 423(b)8 limit, even if your plan does not provide for this course of action to result in the beginning of a new enrollment period. Because this limit is based on the grant price, which is expected to be much greater than the purchase price in this case, remaining in the plan may limit your ability to participate in the following purchase period, which also ends in the same calendar year. As a rule, you should withdraw and forego the impending discount if by not withdrawing you expect to forego an even greater discount at the close of the following purchase period due to the 423(b)8 limit.

Anders Johnson, last modified $Date: 2006/09/04 $