How an ESOP Works

When it comes to the division of ownership of a company, there are plenty of options to be had. Employees can gain ownership in a company by the direct purchase of stock, receiving it as a bonus or stock options, or through a profit sharing plan.  One option that is similar to a profit sharing plan that has become increasingly popular due to its benefits for both the business and its employees is an employee stock ownership plan – usually known as an ESOP. Essentially, an ESOP allows the employees of a company to become primary owners and shareholders.

There are many ways to execute an ESOP, but the long and short of the plan is that employees take ownership through the direct purchase of stock, receiving it as a bonus or through a profit sharing plan.

According to the National Center for Employee Ownership, about two-thirds of ESOPs are used to provide a market for the shares of a departing owner of a closely held and profitable company, whereas the remaining third are generally used as a supplemental employee benefit plan.

Companies that participate in ESOPs set up a trust fund for their employees and make annual contributions that are allocated to individual employees’ accounts within the trust, though the formula used for these allocations often depends on the individual company. Often, this allocation is dependent on the employees’ salaries, though it may also depend on years of service.

Benefits of an ESOP

There are many reasons why an ESOP is beneficial for both companies and their employees, including the following:

  • Tax advantages: When the company sets up the trust fund for its employee-benefit plan, any contributions it makes are then tax deductible. Therefore, through an ESOP, corporations can defer its entire tax bill by rolling sale proceeds into qualifying publicly traded securities, assuming state laws allow such action.
  • Employee motivation: An ESOP can do what even bonuses cannot – they link employee productivity directly to their paycheck. If a company’s workers understand that when business is doing well it will be reflected in their financial situation, it’s easy to see why they are motivated to work harder, reduce mistakes and help their teammates.
  • Financial flexibility for employees: Any employee who holds shares in the ESOP has the ability to hold or sell their portion of ownership at any time. They can sell or gift their shares to any other party in the manner of their choosing, providing them with a great deal of financial flexibility.

What companies should consider ESOPs?

Of course, an ESOP isn’t right for all companies. Here are some characteristics of corporations that will best benefit from enrolling in an ESOP:

  • Privately owned: Because publicly owned companies have to concern themselves with their stock value, the fact that ESOPs come with extra contributions to their employees that tend to reduce earnings is often not welcome by shareholders.
  • Reliable management: ESOPs often strongly rely on the management team to maintain profitability to build confidence in shareholders, which, in turn, grows the business and creates cash flow to pay off any selling shareholders.
  • Diverse shareholders: If a large number of a company’s employees are planning on retiring within a few years of each other, it can cause an imbalance of cash flow. Therefore, a diverse group of shareholders who have a wide range of retirement dates will help balance these monetary issues.
  • Strong history of increasing profits: Because of ESOPs’ dependencies on discounted cash-flow valuation models, a steady increase of profits along with a consistent cash flow are essential for a successful business venture. Volatile earnings can demotivate employees, particularly during a recession.

Though ESOPs are a relatively new business model, more than 12,000 companies across the country are operating under such a plan, according to The National Center for Employee Ownership, and may be a great solution for privately owned companies in need of new way to meet their financial goals.

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