This is written from the perspective from a previous Canadian bank employee, but the ESPP is a popular form of compensation across various jurisdictions
Many companies have employee share purchase plans (ESPP) where purchases of the company’s stock by employees will be matched to a certain amount – usually as a percentage of the employee’s base salary. This is a way for corporates to align incentives for employees and the firm. If the employee has a large lump sum tied to the company’s share price performance, the employee will theoretically be compelled to work harder and in the best interests of the firm.
This is additional compensation and will constitute a taxable benefit, while any share price appreciation from both the employee’s and employer’s contribution will be subject to capital gains taxation. There will be a vesting period for the stock so that if an employee leaves before a certain amount of time from contribution, the company matching will be forfeited.
Every time new hires start, management at companies that have had decent share price performance and a healthy dividend will tell employees to make sure to sign up for the ESPP – it’s “free money”.
Depending on what company you work for, enrolling in an ESPP may be a very good idea that should take precedence over other investing options should you have limited funds.
Almost all banks will have employee share purchase plans with generous matching provisions – dividends from both the shares you purchase and the shares the company contributes to you will be rolled into incremental stock. This applies from the retail level all the way up to the investment banking platform. As such, there is many a TD employee that started as a teller and climbed up to a financial advisor to become a dollar value millionaire despite a relatively modest salary due to the compounding effects of the ESPP (dividend, employer matching and share price appreciation) in addition to prudent saving and other bank perks (mortgage subsidies, loan subsidies).
Criteria for Investing in Employee Stock Purchase Plans
There are two major things to consider when investing – the size of the discount and the riskiness of the stock.
If the discount is 1 for 1 matching or better, enrolling is very compelling, as we will outline in the next section. If the discount is 5% off the market price of the stock, this may not be worth putting all of your eggs in the company basket.
Likewise, a solid dividend paying stock such as TD or TELUS will likely be around for the next 10 years. If you work for a business that is struggling financially and may go bust in a few years, even at 1.5x matching it may not be enticing to purchase the stock.
Why Contribute to the Employee Stock Purchase Plan
Joining the ESPP makes a lot of sense. It is most easily framed from an investing standpoint or a direct cash flow standpoint.
Let us take the National Bank of Canada for example (TSX: NA) – at 12x Price-to-Earnings, is it a good purchase? This is a well covered stock and not an easy call to make. Assuming the market is somewhat efficient, NA may be a fair investment that will offer a fair risk adjusted return over time. It has a dividend yield of 3.7%, which makes it acceptable for income investors.
Now as a National Bank employee, you can effectively purchase NA stock at 6x price earnings because every dollar you put in will be doubled. The dividend on a safe stock is now over 7%. Is NA stock a buy at 6x P/E? We still do not know, but it sure seems like it.
The same logic applies for most other strong, oligopolistic companies without unsustainable debt loads. Equity research analysts will often say, “TD Bank is an excellent company, but the stock is expensive.” However, at half the price, you are almost certainly purchasing below fair value. The ESPP is excellent in this way because the company does not necessarily have to be that good for participation to be a sound decision.
Another way to look at the ESPP is a straight cash flow. Assuming that it is capped at 5% of salary, an employee is getting a 5% raise by participating.
A lot of employees do not enroll in the ESPP immediately because they plan on leaving the firm. A lot of the time, new hires think that they can get a better job and do not want to tie up some of their income. The reality is that a lot of people end up staying a lot longer than they originally anticipated – especially if they are unable to land other jobs or it ends up working out at the original company. Usually, there employees rue not having enrolled early. Enrolling comes with a real call option – sticking around will be lucrative, but leaving has limited downside as it means that the company match portion goes away but dividends and capital gains are kept.
One last consideration is that for many young professionals, they tend to spend according to their paycheques. Should an immaterial portion of salary be docked off into the ESPP, they will find that they have a large amount of savings that they did not know about – especially after the compounding of dividends, matching and capital gains.
Is Buying Your Own Company’s Stock Risky?
The main risk is volatility in the underlying stock. As outlined above, if someone works for a company that has a strong business moat and high barriers to entry in its industry, share prices are not severely at risk – share prices by more than half to make up for the “free money” and dividends that are reinvested. If there are only three telecommunications firms in your country and they have a history of bumping up dividends while maintaining prudent financial leverage and you work in one of them, it is unlikely that you will be faced with this sort of event.
Especially in secondary markets such as Canada and Australia, utilities and telecom companies have oligopolistic power – less so due to protectionism and more so due to the population base making it difficult for new entrants to the market to get the returns they require for their shareholders.
Similarly, banks also have these attributes (unlike the USA, which is very fragmented and competitive) and are utility like in nature, allowing for them to grow with the economy and population.
Depending on whether you are an employee of a universal bank with an investment banking platform (Bank of America – Merrill Lynch) or a pure play capital markets firm (Goldman Sachs), the risk of the underlying share is very different. Although both are affected by the economy, retail and lending revenues are relatively more sticky compared to investment banking and market making.
When Should You Not Enroll in the Employee Stock Purchase Plan
Despite all of the reasons outlined above, there may be reasons to avoid the ESPP.
The company is inherently risky or financially unsound
If you work for a company that has an extremely volatile stock price and does not have positive carry in the form of a dividend, this may offset the match buffer. Participating in TELUS’s employee purchase plan is probably safe. If you work for Valeant Pharmaceuticals, maybe not.
If the company stock match is poor
Not all companies have generous matching consideration. If the match is thin and the stock is not compelling, it may be prudent to put money elsewhere.
Overreliance on company performance and lack of diversification
A lot of Nortel employees had their fortunes invested in Nortel stock. When the company went under they lost their jobs and lost their savings. This is unlikely across major institutions such as banks or insurers but should be evaluated when there are already large savings tied to the company’s performance due to deferred compensation or other factors.