Everything You Need To Know About An ESOP

ESOPs (employee stock ownership plans) have historically been misunderstood. As a result, they haven’t always been as popular as, say, opting to sell outright to a private equity group. This is largely due to the misconceptions like the idea that selling shares will mean losing control to employees, or that employees will gain access to sensitive company financial information – or even that management or employees will have to fund the purchase themselves. 

Other misunderstandings generally include thinking that ESOPs are expensive to administer, that a huge payroll is required, that the plan will prevent a subsequent sale of the company, and that only specific company types qualify to implement an ESOP. 

None of this is true. 

To help you gain a better understanding of what an ESOP is and how it works, we have answered the most frequently asked questions for employers and for employees. 

Starting With the Basics

Before we answer all those burning questions from both sides of the plan, let’s start with what an ESOP is. 

There are a few different ways to describe and define an ESOP. For instance, you could define an ESOP as an employee benefit plan or as a tax-qualified retirement plan whereby the company sets aside stock in the ESOP to help employees prepare for retirement.

There are also several objectives that can be pursued using an ESOP, including but not limited to motivating employees to perform better, retaining your top talent, and providing business owners with an alternative exit strategy

Before deciding to establish an ESOP, it’s important that you have a firm grasp on what it is that you’re trying to achieve. To help you in this regard, we have narrowed down several essential factors that both employees and employers should know about ESOP plans.

7 FAQs From Employers About ESOPs

1. What is the purpose of an ESOP for my company?

There are various reasons why you, as an employer, would explore an ESOP plan, but in our experience the main purposes behind a decently structured ESOP plan is to either save a company from bankruptcy by raising its value, bring in new owners when the current ones want to exit, or give existing employees a chance to own a piece of the company and use it as a part of your total reward strategy.

2. How is an ESOP plan different to a retirement plan?

Fundamentally, ESOPs are retirement plans and are required to follow all the basic rules for tax qualification and non-discrimination that other retirement plans must adhere to. But where they differ is in some of the rules they must follow, including specific distribution rules, as well as in the advantages in store for employees. These benefits include the ability to make higher annual contributions to an ESOP than to other plans and the potential to receive significant dividends on the stock.

Additionally, a particularly well-designed ESOP has the power to unlock tax benefits that are leaps and bounds ahead of those delivered by a 401(k).

3. How would an ESOP benefit my company?

Let’s start with the fact that according to the Department of Labor, companies with an ESOP tend to outperform those without – and not just in market value, but in terms of ROA and ROE. The study also indicated that ESOP companies boast lower turnover rates. 

This is mostly because an ESOP creates a culture of ownership, where employees feel like partners. As such, these employees are more likely to be loyal, more likely to place a higher value on their performance and as such, work harder to ensure future success.

Another benefit that shouldn’t be overlooked is the way that you can use an ESOP to preserve your legacy by handing your company over to a trusted management team who have a vested interest in the company’s survival. 

4. What types of ESOP plans are there?

There are various types of ESOPs, but the most common in our experience include the popular Employee Stock Option Scheme (ESOS), the Employees Stock Purchase Plan (ESPP), the Restricted Stock Unit (RSU), and Phantom Stocks.

Here is a brief look at each:

  • ESOS: Employees can own company stock as a right (not as an obligation) by buying company shares at a lower price than the current market value. The option is subject to vesting, meaning that it can’t be claimed until employees are fully vested.
  • ESPP: Employees are allotted a certain number of shares in the company at a discount to the stock’s Fair Market Value (FMV) and are required to hold onto their shares for a set period of time after purchase.
  • RSU: Employees receive shares upon the completion of certain conditions, either as part of a specific company or total reward strategy employee performance.
  • Phantom Stocks: Employees receive shares in the company without the actual transfer of the stock itself in an effort to align employees with owners, letting them reap the same benefits without having to give up equity in the company.

5. Can an ESOP lose value?

The short answer is that yes, an ESOP can lose value. However, it can also increase in value. It all depends on how the company is performing in the market, so when your company’s performance drops, the ESOP’s value will decrease or shares will be taken away to pay debts.

6. Do ESOP companies pay taxes?

This is a bit of a layered answer. Yes, every company is entitled to federal taxes however, ESOP shareholders are exempted from such tax. If a company pays income taxes on its profits, it still owes those same taxes to its state and federal governments.

7. Are ESOP plans risky?

We spoke previously about how ESOPs are widely misunderstood for a number of reasons, but perhaps one of the biggest misconceptions is that ESOPs are a huge risk. There’s a certain amount of risk in all business ventures and strategies, however we have found that when an ESOP plan is informed and structured by experts, like the lawyers, consultants, and investment bankers that we rely on to guide our clients through this process, the risk is mitigated. Not to mention the many protections in the law which prevent an ESOP from being too risky. 

6 FAQs From Employees About ESOPs

1. What does an ESOP mean for me as an employee?

As an employee benefit plan, an ESOP essentially gives you ownership interest in the company – interest that takes the form of shares of stock. How this translates is that you have a stake in the company’s profits, however if you aren’t in a senior enough management position, you won’t participate in any day-to-day decision making, hiring and firing decisions, and any other management-related activities. Additionally, it’s important to note that the ESOP won’t guarantee your employment at the company.

2. How is an ESOP different from a company’s 401(k) plan?

We covered this from the perspective of the employer, but let’s take a look at what the difference between an ESOP and a 401(k) means for you, the employee. Firstly, an ESOP invests primarily in an employer’s stock, while a 401(k) plan generally offers various mutual funds in which you can invest funds. 

Secondly, while a 401(k) plans allows you to contribute your own money, ESOP contributions generally come solely from the company.

3. How often will my ESOP account balance change?

Typically, your ESOP account balance will change once a year and you should receive an annual statement detailing the financial activity for that year. This statement should include the updated stock value. 

4. How is the price of the stock in the ESOP determined? 

Generally speaking, the price of the stock in an ESOP is determined by a qualified valuation company who will work with the plan’s trustee and review various factors. These factors include the company’s current performance, its projected performance, comparative performance of similar publicly traded companies, and the overall economic outlook.

5. How can the value of an ESOP increase?

Ultimately, the value of an ESOP is based on the value of the company’s stock, so if you think about it, employees can increase the value of an ESOP account by taking any actions to improve efficiency, cut expenses, and increase revenue.

6. Where is the employees’ portion of the ESOP kept?

Good question! The company stock and cash (i.e. the assets of the ESOP) are held in the ESOP trust. This trust is an entity specially created for the ESOP and your portion of the ESOP assets is recorded in an ESOP account that is established under your name. 

Let Excel Legacy Group Help 

While we hope that this information proves useful and answers your questions, whether you’re an employer or an employee, we understand that implementing an ESOP can be a tricky undertaking. That’s why it’s best to consult with a team of well-versed professionals who are equipped to balance the needs of owners, managers, the company, and its employees.

Talk to us today.