What is an ESOP?

Another option for successful closely held companies is to create an Employee Stock Ownership Plan, or ESOP. An ESOP is a kind of employee benefit plan which allows companies to provide their employees with stock ownership, often at no up-front cost to the employees. In an ESOP, a company sets up a trust fund with new shares of company stock or cash to buy existing shares. Alternatively, the ESOP can borrow money to buy new or existing shares, with the company making cash contributions to the plan to enable it to repay the loan.

How ESOPs work

Regardless of how the plan acquires stock, company contributions to the trust are tax-deductible, within certain limits. Shares in the trust are allocated to individual employee accounts. As employees accumulate seniority with the company, they acquire an increasing right to the shares in their account. According to the National Center for Employee Ownership, over 11,000 companies have an ESOP. The ESOP shares are treated as part of the employee’s total compensation and may be sold when the employee retires or leaves the company, assuming that the employee has had the shares long enough to be fully vested.

The benefits of an ESOP

Pluses include potential tax avoidance for the owner and potential goodwill from the perception that the company has “given” shares to the employees. In addition, an ESOP can help ensure the continuity of the business because the existing employees will remain after the sale and already know how to run the business. Perhaps most important is the intangible motivation to boost employee performance by vesting each employee with an ownership incentive. If the company exceeds its goals, the employees can generate personal wealth through the increased value of their respective ownership shares of the company.

The challenges of an ESOP

Downsides of an ESOP are that they are expensive, complex and time consuming, and require significant administrative resources to administer. In addition, the share price for an ESOP may be lower than from an IPO or third-party sale, and an owner must trust the ability of the remaining employee group to be able to repay the ESOP loan.

For a detailed explanation of ESOPs you can read more here.