To ESPP or Not

If you work for a public company listed in the US such as Microsoft, Intuit, Adobe, Zynga etc, you often have the option to enrol in a program named Employee Stock Purchase Plan (ESPP). ESPP allows an employee to purchase the company stock at a discount, typically 10-15%, to the ongoing market price.

The cost of this discount is borne by the company like any other employee benefit. An added advantage for the company is that it strengthens the incentive alignment: the additional investment in company stock makes the employee more likely to work harder and act in the company’s best interest.

For Microsoft, as of Feb 2021, employees can invest up to 15% of their salaries in ESPP and get shares at 90% of the market price. Here is how it works:

Suppose your monthly salary is ₹200K. If you decide to put the maximum allowed allocation of 15% in ESPP, every month, the company would withhold ₹30K from your salary.

Though the deductions occur every month, ESPP allotment is done only once a quarter. On the 90th day, the ₹90K (3 * 30K) would be used to buy ₹100K (i.e., at 90% of the price) worth of MSFT shares at that day’s closing price¹. Once bought, the shares would hit your brokerage account within a couple of days and you are free to keep them or to sell for an instant profit of ₹10K INR, as you wish.

ESPP seems like a no-brainer, free money and I know several people who max out their ESPP quotas. But if you dig deeper, you will unearth several important disadvantages.

Limited Upside

Since this is a money transfer from the company to employees in addition to the annual compensation, there is always a cap on how much one can invest via this program. Had this been unbounded, it would have been a major loss for the company’s shareholders.

The most you can gain in a year is 1.67% (=100/90 * 15%) of your salary at the maximum allocation. If you allocate less than 15%, gains will be even smaller. US tax regulations too restrict the maximum amount that can be invested in ESPP in a given year at $25,000, though Indian employees are unlikely to hit this limit. The bounded, small upside is why the cost of offering this benefit is minimal to the company, despite the big headline discount number.

To pocket the risk-free ₹10K every quarter, you need to sell the entire ₹100K worth of stocks and bring the money back to India, immediately. The longer you wait, the more you become exposed to potential declines in stock price and USD-INR conversion rate. Selling these shares quickly though has a bunch of problems:

Taxation

An immediate sale would categorize the profit of ₹10K as Short Term Capital Gains (STCG). As of Feb 2021, STCG on securities not listed in India are taxed at your marginal tax slab rate. As someone in the 30% bracket, you will have to shell out ₹3K as taxes.

Transaction Costs

To make matters worse, you will also have to pay commissions and foreign exchange transactions charges. Your broker such as Morgan Stanley, Fidelity, E-trade etc will charge a fixed commission on the sale transaction. To bring the money back to India, you would need to do an international wire transfer which is not free. This could also involve an intermediary bank, which too would levy charges for processing the transfer.

That’s not it. Your bank back home in India will charge a commission for the USD to INR conversion: typically 1-2% on the mid-market rate one sees on Google, XE etc. It will also charge a fixed fee for processing the incoming international transfer.

A model transaction via Morgan Stanley could look this:

[(₹100000 - ($5 +$10 + $3) * ₹72)] * (100-1.5%) - (30% * ₹10000) - ₹300

= ₹94200

This assumes a $5 as the fixed, per-transaction commission, $10 as International Wire Transfer fee and $3 charged by Citibank, the intermediary bank, 1.5% commission on the currency conversion, 30% as tax rate, ₹300 as the fixed fee charged by the Indian bank and $1 = ₹72

After transaction costs and taxes, you are left with ₹4.2K – nothing to sniff at but far less than the hoped-for ₹10K.

Decreased Liquidity

Small post-tax, post-fee gains are not the only issue. Enrolling in ESPP has another major disadvantage: it reduces your monthly take-home drastically. From ₹200K to ₹170K, in this example.

Take-home is the amount that gets deposited in your bank account at the end of the month and is important for most people, for different reasons. A reduction of 30K is not insignificant. Even if you regularly sell the shares at the end of each quarter, the spiky cash flows can put your monthly budget under unnecessary pressure.

If you hold the additional shares for a long time (2+ years), prospects seem to change:

1. Tax rate reduces from 30% to 20% with indexation benefit
2. Fixed transaction costs reduce because of few large sales, rather than one every quarter
3. Decreased liquidity can be treated as an upfront saving, and monthly budgets accordingly adjusted

Seems better, right? The caveat, however, is that this is no longer risk-free: you are actively betting on the company’s stock going up, or at least not going down for 2+ years of your holding period. If the share price declines or if the INR moves up against the USD, or a combination of these two, you stand to lose far more than you gained from the upfront discount. Did I mention that the transaction costs are applicable even if you make a loss?

Not selling the shares every quarter implies actively choosing to invest 30K a month in the company’s shares. This introduces other significant problems: Concentration Risk and Opportunity Cost

Concentration Risk

Your job security itself and the annual compensation is tied to the company. Stock grants likely form a large part of your package. If you put an additional ₹30K every month in the company shares, an even larger portion of your wealth becomes tied at the hip to how well the company stock does².

You know what they say about putting all the eggs in one basket. The day some catastrophe strikes and the company has to downsize, not only can you lose your job, but your savings (in the form of unsold shares) would also evaporate because the market would be badgering down the stock. You will be badly hit on two fronts.

Do you wholeheartedly believe that the company you work at is immune from disruption, regulatory changes, cross-geo politics, accounting frauds, pandemics etc? I would bet that employees of Enron, GE, Nokia, RIM (BlackBerry) etc thought on similar lines at their company’s respective peaks. Their lifelong savings were wiped off in a short period.

Even if an extreme event does not occur, a single company’s stock will always be too volatile to park the majority of your savings. Another subtle and often missed risk is the opportunity cost.

Opportunity Cost

Selling your shares at a higher price than the discounted buying price is not good enough. Over your holding period, if the company’s shares increase but less than the overall market, you lose an opportunity to have made even more money. And money not earned is money lost aka opportunity cost.

What makes you confident that shares of this particular company will outperform those of Apple, Amazon, Google, Shopify, Tesla, Netflix, Airbnb et al for the foreseeable future? What does the public at large not know that you, a cog in the giant company wheel, do? Being able to outperform the market doing active stock picking over the long term is ridiculously hard. You can read my thoughts on this topic here.

Buying more shares of the company you work at does not get you brownie points for loyalty. If you had not been working at your current company or if not for ESPP, would you still invest ₹30K per month in its shares? Think for yourself. After all, your and your family’s financial wellbeing is at stake.