Know the Risks of Your Employee Stock Purchase Plan

When I was in California recently, I met with a prospective client and did a second opinion financial review of his situation. He has $5 million in his company’s employee stock purchase plan (ESPP). I can’t help but feel a bit dizzy, that feeling you get when you’re standing on the edge of a tall building without any protection.

I have a friend who was a senior engineer at MCI WorldCom. He also participated in this company’s ESPP. In only a few years Worldcom went from being a no-name, little known company to acquiring the second largest telecom at the time – MCI – and its stock price went up tenfold. The value of my friend’s ESPP account went from $300,000 to over $3 million and he looked extremely smart by not diversifying at all. (For more, see: What Does Investment Diversification Really Mean?)

The rest of the story you all know. MCI WorldCom filed for chapter 11 bankruptcy in 2002, due largely to corporate fraud committed by their executives. Its stock price plummeted to zero and my friend lost every dime in his ESPP.

ESPPs Explained

So what exactly is an ESPP? An ESPP enables a company employee to purchase company stock through payroll deductions. These kinds of plans are very popular among tech companies because they are considered a very effective way to align the interests of the employees and the firm.

A typical ESPP usually allows an employee to purchase company stock at a discount of up to 15% to 20% and requires the employee to hold the stock for at least one year. After a year, the employee is allowed to diversify. But few do, much to their financial peril. Here are the common reasons they don’t: 

  1. Inertia. Most people just have this deep-seated status quo bias. If things ain’t broke, why change? Payroll deduction is automatic, but to diversify the employee would actually need to create another brokerage account, move their company shares there and sell them and buy other stocks or funds. This is just too much work for comfort.
  2. Affinity. Most people also have a deep-seated affinity bias. They are familiar with the company, they like their colleagues, so they also like the company stock. It may be subconscious, but they don’t want to sell their stock, since selling feels like separating.
  3. Overconfidence. Since they work for the company, they think they know everything about the company. They feel as though they are in control, therefore a concentrated position doesn’t feel as risky to them.
  4. Capital gain tax. Since shares are purchased at a discount, capital gains taxes have to be paid when they are sold. Many people would rather not pay taxes, and so they continue to delay selling their shares.

Diversification

All of these are not good reasons not to diversify. You may think that since you work in the company, you are on top of things. Well, my friend who worked for MCI WorldCom thought so as well. So did those employees who worked for Enron and Lehman Brothers, and many lost everything.  

You don’t know what you don’t know. If you’ve read this far, you probably have a pretty sizeable ESPP. Do me a favor, take this tiny step: put a date on your calendar to diversify your concentrated position. This little nudge might just be enough to overcome your inertia bias. (For more, see: Top Rules of Thumb for Retirement Savings.)