An employee stock ownership plan (ESOP) is a benefit for employees in the form of company stock. Note that this is very different from an employee stock option plan (ESO), which does not provide ownership. There are many reasons companies implement ESOPs (see Benefits of ESOPs section below). One of the most important is that these plans help align owner and employee incentives. At its core, an ESOP is a way for employees to own a stake in the company they work for, creating a powerful sense of partnership and commitment between them as workers and their employers as shareholders.
History of employee stock ownership plans
The first ESOP was created in 1956 by a lawyer and economist named Louis Kelso as a succession planning tool. At the time, the founders of Peninsula Newspapers were looking to transition ownership of their company to their most trusted employees.
Kelso structured the ESOP with a vision in mind: employees are the most logical buyers (and future owners) of most businesses, since they know the companies they work at better than anyone else. The plan was successfully implemented, and Peninsula Newspapers was quite successful for the next quarter century, paying out millions of dollars to the ESOP’s participants.
Employee stock ownership plans didn’t become more commonplace in the United States until the 1980s. In an attempt to stimulate the economy and encourage owners to pass the torch to future generations, specific provisions were added to the Tax Reform Act of 1984 that made ESOPs even more beneficial than they were before. Two of them are still in effect today:
- Deferred capital gains tax: this allows owners to make their stock liquid and have tax favorable treatment.
- Deductible dividends: this enables an ESOP to purchase large shares of a given company.
How ESOPs work
The first thing to understand about how ESOPs work is that they are set up as trust funds. These can be funded in several ways, including via company contributions (most common), by borrowing money from a bank, or through a company contributing cash to an employee stock ownership plan which the ESOP then uses to buy shares of the company.
Company contributions mean that the business gives employees stock shares in the company instead of cash for a retirement plan. Essentially, ESOP shares are usually granted as part of employee compensation, as opposed to them having to spend their own money to buy shares.
Once a trust is set up and funded, employees are allocated shares in the ESOP. The allocation is often determined by things like title, tenure, and salary. As the company grows and becomes more successful, the value of the ESOP shares increases. When an employee is ready to leave the company, they can sell their shares back to the company and receive a certain amount of cash based on the number of shares they sold and the current value of the company.
It’s easy to see that employee stock ownership plans are a win-win for business owners and their employees, since incentives are aligned to grow the company and reap joint financial rewards.
Benefits of ESOPs
The most recent data on ESOPs is from 2020 and shows that there are nearly 6,500 plans with 14 million participants in the United States. What are the primary benefits that make ESOPs such an appealing tool for business owners?
- Employee retention
Employee stock ownership plans are a great way to keep your best employees. In fact, ESOP companies are 3 – 4 times more likely to retain staff than non-ESOP companies. When businesses implement ESOPs, they’re giving their employees a strong financial incentive to stick around. For employees thinking about their long-term plans, knowing they have a retirement plan in the form of a company ESOP can be very desirable. - Employee motivation
ESOPs align employee-employer incentives. ESOP companies grow faster than non ESOP companies, and have increased productivity. Knowing that they have a true stake in their employer’s company can push employees to be as productive as possible, making the business more valuable, which results in a better result for everyone involved when it comes to a future cash payout. - Market competitive
While businesses expect 2024 to be a bit more company-friendly when it comes to hiring compared to the previous three years, the labor market is still tight and business owners acknowledge that employees still hold a strong position in the market. Implementing a benefits plan like an employee stock ownership plan can help businesses – especially smaller ones that struggle to compete against larger companies – stand out as they look to hire. - Tax advantages
In addition to the 1980s ESOP tax benefits mentioned at the start of this blog post (deferred capital gains tax and deductible dividends) that are still in effect today, there are several other newer tax advantages that have been added over the years, including tax deferrals for employees, retirement rollover flexibility, and tax deductibility for companies (which results in extra cash flow). - Succession planning
This is perhaps the most interesting and important long-term benefit to employers. Let’s revisit Louis Kelso and the first employee stock ownership plan, which was created first and foremost as a succession planning tool. Prior to this, if a business owner wanted to retire, they only had a few options:- Selling a fraction of the business to employees and enabling a stock redemption plan for the rest: This allows for an owner cashout, but the debt has to be repaid with after tax dollars, which usually means the debt lingers for many years.
- Selling to a competitor: This can erase an owner’s legacy, not to mention the company identity once it is absorbed into the buyer’s portfolio. Oftentimes, a buyer will pay in both cash and earnout, requiring owners to stay on for years when they are ready to retire.
- Selling to a venture capital firm: Appealing on the surface due to the high dollar amount VCs are often willing to pay for a business, it can be another story after the deal is closed. Layoffs should be expected, along with a shift in focus from customer value to raw numbers, and various cost-cutting measures.
ESOPs are a much more flexible, business and employee-friendly way to successfully cash out and pass a business on to the next generation.
Challenges with employee stock ownership plans
ESOPs are not without their challenges. Primary considerations include:
- Education and Implementation
The first hurdle is understanding the ins and outs of ESOPs as an owner, and explaining them to employees. ESOPs can be complicated to implement, and require legal and financial guidance when doing so. One example of an initial hurdle is the company and share valuation process, which must be done by a third party. - Not easily available to very small businesses
ESOPs should only be considered by firms with a minimum of roughly 20 employees, though that is more of a guiding principle than a hard rule. This is to ensure that the costs of implementing and maintaining an ESOP are sustainable, that there is sufficient cash flow, and that the business is able to maintain regulatory compliance. - Reduced diversification
For both owners and employees, having a large portion of retirement savings tied up in one asset (in this case, an ESOP linked to one business), can be risky if the company doesn’t perform well. It’s important to consider individual financial situations and consult with appropriate experts.
