Employee Stock Ownership Plan (ESOP)

What Is an Employee Stock Ownership Plan (ESOP)?

An employee stock ownership plan (ESOP) is an employee benefit plan that gives workers ownership interest in the company; this interest takes the form of shares of stock. ESOPs give the sponsoring company—the selling shareholder—and participants various tax benefits, making them qualified plans. Employers often use ESOPs as a corporate-finance strategy to align the interests of their employees with those of their shareholders.

Key Takeaways

  • An employee stock ownership plan (ESOP) gives workers ownership interest in the company.
  • An ESOP is usually formed to allow employees the opportunity to buy stock in a closely held company to facilitate succession planning.
  • ESOPs encourage employees to do what's best for shareholders since the employees themselves own stock.
  • ESOPs provide companies with tax benefits, thus incentivizing owners to offer them to employees.
  • Companies typically tie distributions from the plan to vesting.

Understanding Employee Stock Ownership Plans (ESOP)

An ESOP is usually formed to facilitate succession planning in a closely held company by allowing employees the opportunity to buy shares of the corporate stock. ESOPs are set up as trust funds and can be funded by companies putting newly issued shares into them, putting cash in to buy existing company shares, or borrowing money through the entity to buy company shares. ESOPs are used by companies of all sizes, including a number of large publicly traded corporations.

Since ESOP shares are part of the employees' remuneration package, companies can use ESOPs to keep plan participants focused on corporate performance and share price appreciation. By giving plan participants an interest in seeing the company's stock perform well, these plans supposedly encourage participants to do what's best for shareholders, since the participants themselves are shareholders.

Upfront Costs and Distributions

Companies often provide employees with such ownership with no upfront costs. The company may hold the provided shares in a trust for safety and growth until the employee retires or resigns. Companies typically tie distributions from the plan to vesting, which gives employees rights to employer-provided assets over time; typically, they earn an increasing proportion of shares for each year of their service.

When a fully vested employee retires or resigns from the company, the firm "purchases" the vested shares back from them. The money goes to the employee in a lump sum or equal periodic payments, depending on the plan. Once the company purchases the shares and pays the employee, the company redistributes or voids the shares. Employees who leave the company voluntarily cannot take the shares of stock with them, only the cash payment.

Fired employees often only qualify for the amount they have vested in the ESOP.

Employee-owned corporations are companies with majority holdings held by their own employees. These organizations are like cooperatives, except that the company does not distribute its capital equally. Many of these companies only provide voting rights to particular shareholders. Companies may also give senior employees the benefit of more shares compared to new employees.

ESOP and Other Forms of Employee Ownership

Stock ownership plans provide packages that act as additional benefits for employees to prevent hostility and keep a specific corporate culture that company managements want to maintain.

Other versions of employee ownership include direct-purchase programs, stock options, restricted stock, phantom stock, and stock appreciation rights. Direct-purchase plans let employees purchase shares of their respective companies with their personal after-tax money. Some countries provide special tax-qualified plans that let employees purchase company stock at discounted prices. 

Restricted Stock, Stock Options, and Phantom Stock

Restricted stock gives the employees the right to receive shares as a gift or a purchased item after meeting particular restrictions, such as working for a specific period or hitting specific performance targets. Stock options provide employees with the opportunity to buy shares at a fixed price for a set period, while phantom stock provides cash bonuses for good employee performance.

These bonuses equate to the value of a particular number of shares. Stock appreciation rights give employees the right to raise the value of an assigned number of shares. Companies usually pay these shares in cash.

What Does ESOP Stand for?

ESOP stands for employee stock ownership plan. An ESOP grants employees company stock, often based on the duration of their employment. Typically, it is part of a compensation package, where shares will vest over a period of time. ESOPs are designed so that employees' motivations and interests are aligned with those of the company's shareholders. From a management perspective, ESOPs have certain tax advantages, along with incentivizing employees to focus on company performance.

How Does an Employee Stock Ownership Plan Work?

First, an employee stock ownership plan is set up as a trust fund. Here, companies may place newly issued shares, borrow money to buy company shares, or fund the trust with cash to purchase company shares. Meanwhile, employees can accumulate a growing number of shares, an amount that can rise over time depending on their employment term. These shares are meant to be sold only at or after the time of retirement or termination, and the employee is remunerated the cash value of their shares.

What Is an Example of an Employee Stock Ownership Plan?

Consider an employee who has worked at a large tech firm for five years. Under the company’s employee stock ownership plan, they have the right to receive 20 shares after the first year, and 100 shares total after five years. When the employee retires, they will receive the share value in cash. Stock ownership plans may include stock options, restricted shares, and stock appreciation rights, among others. 

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