What is an ESOP?

An Employee Stock Ownership Plan (ESOP) is an employee retirement plan that allows employees to become partial owners of their company by receiving shares of the company’s stock. This retirement plan option is designed to provide employees with an ownership interest in the company, which serves as an extra form of compensation and incentivizes employees to personally care about and contribute toward the company’s success. 

Many well-known corporations, including WinCo Foods and Starbucks, successfully established ESOPs for their employees and have seen excellent growth results. There is, in fact, substantial scientific evidence that ESOP firms are better at engaging their employees and tend to outperform their non-ESOP counterparts in sales growth by an average of 2.3%.

How do ESOPs Work?

ESOPs, or Employee Stock Ownership Plans, come in two main types: Leveraged ESOPs and Non-leveraged ESOPs. Each type of plan has its own set of characteristics, advantages, and disadvantages. AVGI explores each type of ESOP and how they work.

Non-leveraged ESOP (Traditional or Contributory)

In a non-leveraged ESOP (or contributory ESOP), the employer makes cash or stock contributions to fund the plan completely internally.  Non-leveraged ESOPs are advantageous for companies that have sufficient cash flow to fund the ESOP and want to avoid the financial risk associated with a leveraged ESOP. However, the main disadvantage is that it may limit the company’s financial flexibility.

How do ESOPs Work? Non-Leveraged ESOP Example

AAA Corp. creates a non-leveraged Employee Stock Ownership Plan (ESOP) for its employees. It first conducts a feasibility study to determine whether an ESOP is suitable for the company and its employees. Then, it designs the plan’s structure, outlining the rules for the allocation of shares, employee eligibility criteria, and vesting schedule, which it documents extensively to satisfy regulatory requirements.

Next, the company obtains an independent ESOP valuation of the company’s shares to determine the price at which the shares should be allocated to the ESOP. AAA Corp. files the necessary documents with the Department of Labor and IRS to ensure compliance with all ERISA (Employee Retirement Income Security Act) and IRS regulations for ESOPs.

AAA Corp. acquires the funds for the ESOP from the company’s pre-tax revenues, which they contribute to the ESOP fund in a yearly tax-deductible donation. The fund then uses the cash to purchase company shares. Once the ESOP is formed and funded, AAA Corp. employees begin the vesting process.

Each employee can start receiving stock after a full year at AAA Corp. They continue to become eligible for more stock the longer they stay with the company. Once vested, employees are entitled to receive the shares or cash equivalent upon retirement, termination, disability, or death. The employees can choose to accept the distributions in a single lump sum or installments and choose an immediate or deferred distribution schedule.

By creating a non-leveraged ESOP, AAA Corp. allowed its employees to become partial owners of the company, ensuring their interest in the long-term success of the business.

Leveraged ESOP

Leveraged ESOPs involve the ESOP trust borrowing money to buy shares of the company. The company then makes cash contributions to the ESOP trust, which are used to repay the loan. This allows the company to fund the ESOP gradually using pre-tax dollars and enables employees to acquire ownership without having to put up their own money. The main advantages of leveraged ESOPs are that they enable the company to finance its growth and provide a market for an owner to liquidate their shares in the company. Employees also benefit from the potential to acquire ownership with no personal monetary investment. 

However, the downside of leveraged ESOPs is the financial risk involved, as the company and its employees are dependent on its financial performance to repay the loan.

How do Leveraged ESOPs Work? An Illustrative Example

XXX Corp. decided to establish a leveraged Employee Stock Ownership Plan (ESOP) to provide an ownership stake to its employees. The process of creating a leveraged ESOP involves several steps. First, the company must establish a trust to hold the ESOP shares on its employees’ behalf. Then, the trust borrows funds from a financial institution, using the borrowed money to purchase company shares. 

The regulatory requirements include ensuring that the ESOP is ERISA (Employee Retirement Income Security Act) and Internal Revenue Code compliant. This involves conducting a valuation of the company’s shares, providing disclosures to the employees about the ESOP, and adhering to fiduciary responsibilities in managing the plan.

The funds for the ESOP are acquired through a loan taken out by the ESOP trust. The company makes tax-deductible contributions to the ESOP trust to enable the trust to repay the loan. As the trust repays the loan, the ESOP acquires shares from the company and allocates them to the employees’ ESOP accounts. As the employees pass vesting milestones, they become entitled to more shares of company stock. 

Employees can utilize the ESOP stock options by receiving shares allocated to their accounts as they vest. They can then choose to hold onto the shares and benefit from any potential increase in the company’s value, or they can sell the shares back to the company when they leave the company or retire. A standard “put” option in the ESOP formation documents requires the trust to buy back the stock from the employee when they leave the company, which provides the employee with ultimate liquidity. Participating in the company, ESOP allows employees to share in the company’s success and accumulate wealth for their future.

Comparing Leveraged vs. Non-Leveraged ESOPs

The main difference in the two types of ESOPs lies in how they are financed. Leveraged ESOPs involve borrowing funds from an external lender to acquire shares, while employer contributions entirely fund non-leveraged ESOPs. 

Leveraged ESOPs carry significant financial risk for both the company and the employees. The vesting schedule for employees in leveraged ESOPs is often tied to the ESOP loan repayment plan.

Non-leveraged ESOPs do not involve taking on debt, making them less risky for the company. However, since internal company funds completely fund these plans, the company may have less liquidity.

How Does ESOP Vesting Work?

“Vesting” in an ESOP refers to the process by which employees gain ownership of the shares allocated to them over time. It’s a gradual process through which employees become entitled to the shares provided by the ESOP. 

In a non-leveraged ESOP, the vesting process usually follows a predetermined schedule outlined in the plan. Common vesting periods for non-leveraged ESOPs include 3-6-year schedules, where employees become progressively vested in the shares over the specified period. Once vested, employees have the right to the shares even if they leave the company before retirement.

In a leveraged ESOP, the vesting process works similarly to a non-leveraged ESOP, with a predetermined vesting schedule. However, in a leveraged ESOP, the shares allocated to employees are used to repay the loan taken out to purchase the company shares. The vesting process is linked to the loan repayment schedule.

ESOP Advantages for Employees

Employees can benefit tremendously from ESOPs, regardless of how the ESOP is formed (leveraged or non-leveraged). Here we explore some of the main ESOP advantages for employees

1. ESOPs allow employees to receive additional compensation beyond their paycheck. With an ESOP, they also receive shares of company stock (often after a vesting period), which can increase in value over time. This gives employees a direct stake in the company’s performance and success.
2. ESOPs enable employees to acquire ownership without investing their own money. 
3. ESOPs encourage employees to stay in the company and motivate them to perform excellently. Employees become directly invested in the company’s success and see the direct results of the company’s success in the increased value of their shares in the company.

Both leveraged and non-leveraged ESOPs effectively provide employees with additional compensation, a personal stake in the company’s success, and a valuable asset for the future. The main difference between the two types of ESOPs lies in how the owners finance the plans.

ESOP Advantages for Non-Employee Shareholders

ESOPs also offer benefits for company shareholders who are not employees of the company, such as external investors or relatives of the owner who own company stock. 

The main advantage for non-employee shareholders is that ESOPs create a market for all company shareholders to sell their shares in the company, providing liquidity for their stake in the company. This is particularly beneficial in closely held companies where there may not be a ready market for the shares.

ESOP Disadvantages for Non-Employee Shareholders

However, there are potential disadvantages of ESOPs for non-employee shareholders.

1. In a closely held company, selling to an ESOP may limit the pool of potential buyers for the business, potentially affecting the price at which they can sell their company shares. 
2. When forming a leveraged ESOP, the company takes on debt to fund the transaction, which creates a liability and negatively affects the company’s value.

So, while ESOPs can offer significant benefits for non-employee company shareholders, it’s essential to examine the bigger picture of the company’s circumstances and the potential impact on all stakeholders before implementing an ESOP.

ESOP Advantages for Employers

ESOPs also offer several advantages for employers. Let’s examine some of the pros for employers. 

1. ESOPs are an attractive employee compensation benefit and are often very effective in recruiting and retaining top talent. 
2. By offering employees a stake in the company through stock ownership, ESOPs align employees’ interests with those of the company, increasing employee motivation, loyalty, and productivity. By extension, this often increases company sales and profitability, among other KPIs.
3. ESOPs also provide a marketplace for business owners to sell all or part of their ownership stake in the company while providing employees with an ownership interest. Selling shares to the ESOP also allows the owner to utilize the Section 1042 rollover tax benefit, eliminating the personal capital gains tax. This option can be particularly beneficial when business owners want to retire or exit the company. However, it is essential to weigh all potential aspects of the deal. Selling to the ESOP may not always be the most beneficial option for the owner. 
4. Owners fund Leveraged ESOPs with borrowed funds, which they then use to acquire company stock. Leveraged ESOPs allow employers to fund the plan with pre-tax dollars and can effectively finance growth or provide liquidity to business owners.
5. Non-leveraged ESOPs are funded directly by the company and allow the company to establish an employee retirement plan without taking on debt.

ESOP Disadvantages for Employers

1. ESOPs come with high administrative and compliance burdens. ESOPs are subject to complex regulatory requirements, such as yearly ESOP valuations and mandatory financial reporting. Ensuring compliance can require significant time and resources from the employer, increasing the cost of administrative operations.
2. In the case of leveraged ESOPs, the company takes on debt to fund the ESOP. This poses a financial risk to the company during economic downturns or other business challenges. 
3. In addition, forming a leveraged ESOP dilutes the company’s value immediately since the company guarantees the loan. The additional liability undermines the company’s value until the company pays off the loan.

While ESOPs offer several benefits for employers, including enhanced employee engagement and a tax-advantaged approach to exit planning, they also come with significant complexities and potential financial risks that employers should carefully consider. AVGI advises companies considering ESOP formation to discuss the possible impacts on the company with a qualified financial professional. Many companies take advantage of AVGI’s 30+ years of experience valuing ESOPs to help them make that critical decision. Call us if you’re considering forming an ESOP so you can rest assured that you are making a value-enhancing decision.

In Conclusion: How Do ESOPs Work?

Employee Stock Ownership Plans (ESOPs) offer a compelling opportunity for both companies and employees to share in the success and growth of the business. Whether through non-leveraged ESOPs funded by employer contributions or leveraged ESOPs utilizing borrowed funds, these plans can be powerful tools to enhance employee engagement, loyalty, and overall company performance. By exploring the various structures, advantages, and value of ESOPs, companies can make informed decisions about implementing these retirement plans to foster a culture of ownership and drive sustainable success.