An ESOP (Employee Stock Ownership Plan) is a retirement plan that allows employees to own part of the company they work for by granting them stock in the company.
Giving stock to employees serves two core functions:
- It changes the company’s ownership structure
- It creates an additional retirement benefit for employees
These two changes can have a multitude of downstream effects across the organization. We’ll touch on those shortly; first, we need to understand the rationale behind ESOPs in the first place. Unfortunately, a lot of the info currently out there on ESOPs isn’t really written for those of us without finance degrees or an MBA.
This guide is for the rest of us. Whether you’re a business owner exploring what ESOPs have to offer or you just became an employee-owner and want to understand your new benefit, this guide is designed to help you make the most of your employee-ownership journey.
Looking for information about a specific ESOP topic?
Structure: What Do ESOPs Look Like?
How does an ESOP Work?
Who does an ESOP benefit?
ESOPs vs. other exit strategies
Why not ESOPs for everyone?
ESOP FAQs & Misconceptions
ESOPs as a Means of Transferring Ownership
The primary function of an ESOP (and often the reason one is put in place to begin with) is to transfer ownership of a company from its current owner(s) to the employees. In most cases, the process is prompted by a business owner looking to retire, take a step back from their business, or just exchange their stake in the company for more liquid assets that can be invested elsewhere. But that’s not an ESOP’s only purpose.
ESOPs as a Retirement Asset
Just like any other retirement plan, ESOPs serve as an employment benefit for the company’s workers. The United States Internal Revenue Service (IRS) classifies ESOPs as a “Qualified Retirement Plan or QRP,” just like 401(k)s and other profit-sharing plans. Annual contributions are made to an employee’s account throughout their tenure at the company. When a worker leaves or retires from the organization, they are paid out the value of their account.
ESOPs vs. 401ks and Other Retirement Plans
Though ESOPs are in the same class as other retirement plans, a few crucial differences make them distinct from others in the QRP category.
Unlike traditional retirement plans where investment options are diversified across holdings in many different companies, ESOPs only hold the company’s own stock. This means ESOP account balances are directly tied to the success of the company. If the company does well and becomes more valuable, employee accounts holding that stock increase in value too.
Another key difference is that only the company contributes to ESOP accounts; in most cases, employees do not invest any of their own money or assets to receive the benefit. Simply being employed at the company on a full-time basis is typically sufficient to be enrolled in the plan.
Some employers even offer both a 401k and an ESOP that work together as part of their total compensation package.
Employee-owners here at GreatBanc have a 401k plan and an ESOP! Check out our open positions and learn more about the benefits of joining the GB team.
ESOP Structure: A Foundation of Trust
No, really. Under the hood, every ESOP is just a trust.
What’s a Trust?
A trust is a legal arrangement that requires one party (the trustee) to hold and manage assets on behalf of another (the beneficiary). By law, decisions made and actions taken by the trustee must be in the interest of the beneficiaries.
In an ESOP trust, employees participating in the plan are its beneficiaries, meaning all decisions made on the plan’s behalf must benefit them. You might also hear employees referred to as participants, employee-owners, or beneficiaries—it all means the same thing in most cases.
What’s a Trustee?
As the astute among you may have guessed, a trustee is assigned to oversee a trust. Trustees are a type of fiduciary, meaning they are legally obligated to consider the needs of the beneficiary exclusively.
An ESOP trustee’s primary duty is to advocate for the employees and provide the company’s leadership with guidance regarding decisions affecting the ESOP. They also ensure regulatory requirements are adhered to, and that the plan is administered according to its founding documents.
GreatBanc is a trustee!
We specialize in helping new and existing employee-owned companies get the most out of their ESOP.
How Does an ESOP Work?
Because implementing an ESOP means transferring ownership, a formal, legal transaction needs to take place. Let’s take a look at a simplified version of the process:
By the end of the transaction, the ESOP itself becomes the new owner of the shares, holding them on employees’ behalf until they part ways with the company.
Who Benefits from an ESOP?
When executed correctly, an ESOP is a win-win-win scenario: the company, its owners, and the employees all benefit from the plan.
How Employees Benefit from an ESOP
For employees, the introduction of an ESOP means more long-term financial security. They receive an additional retirement benefit that they didn’t have prior to the ESOP transition.
By the time someone has completed decades of service at a company, their ESOP account can often be worth a significant sum that meaningfully impacts their retirement—all at no cost to them. Employees also gain the opportunity to have a direct impact on their retirement account value. Additional value generated for the company means more retirement funds for employees and their families. This triggers a meaningful culture shift as people start working for themselves and another, and not just for a paycheck.
Upsides for employees working at ESOP companies:
- Receive an additional retirement benefit at no cost
- Potential for significant retirement account growth
- Get to share in the economic success of the company they work for
- Takes part in ownership culture and the benefits that come along with it.
How Companies Benefit from an ESOP
There are significant upsides for companies implementing an ESOP, especially when it comes to corporate taxes. Companies owned entirely by an ESOP are not required to pay ANY federal corporate income tax (21%). ESOP plan contributions are also tax deductible, which can be a meaningful boost for partial ESOP companies, too. These substantial savings can then be reinvested in personnel and other initiatives around the company.
Companies also reap some trickle-down effects from the impact on employees. Research shows that employee-owned companies are more productive and have better employee retention rates than their non-ESOP counterparts—a figure largely attributed to motivational aspect of giving employees a piece of the wealth they’re helping to create.
ESOPs can be a big difference-maker for recruiting, too. An extra retirement plan on top of the typical 401k can really move the needle for candidates who are making the decision of where to go next.
Benefits for companies that implement an ESOP:
- Significant tax benefits and advantages
- More committed workforce that’s invested in organization’s success
- Keeps company independent, protects staff and management talent
- Additional benefit for total compensation to attract employees
- Allows additional capital strategies via leveraged (i.e. loan-based) ESOP structures
How Business Owners Benefit from an ESOP
For business owners, ESOPs are all about preparing for the future. By selling all or some of the business, owners gain liquid assets that are more flexible, able to be used for other investment opportunities, or to plan their own retirement.
However, an owner doesn’t necessarily have to leave the company or step back when transitioning ownership via an ESOP. Ongoing long-term involvement is one of the things that makes ESOPs so attractive to business owners. When selling to an ESOP, an owner gets to choose the extent to which they remain involved in the organization, which often isn’t the case in other types of sales.
If an owner wants to maintain an active role within the company, they can sell a minority interest to the ESOP. If they’re looking to take a step back, they can sell a controlling interest in the firm (or all of it). In many transactions, the selling shareholder moves to a more senior, advisory role in the company, like a board seat, once the ESOP transition is complete. In certain cases, an owner might also be able to qualify for deferral of capital gains taxes.
ESOPs vs. Traditional Exit Strategies
Traditional methods for transferring ownership of a business (sell, get acquired, merge, etc.) can often have devastating impacts on the companies and employees involved in the transaction.
Unfortunately, mergers and acquisitions are very often followed by layoffs for both organizations. It’s common to see teams split apart, departments reorganized, and reliable, long-standing leaders relieved of their roles. All of these actions can have disastrous effects on a company’s culture, productivity, and success. Even without taking any of those measures, integrating two workplace cultures can be a tough process all its own.
Some advantages of ESOPs vs. traditional business exit strategies:
- Employees share in the company’s financial success
- Better workforce performance – On aggregate, employees are more productive and motivated once becoming owners
- Avoid layoffs
- Avoid destabilizing management shake-ups and costly staff restructuring
- Company continues to exist as it is, not sold off in pieces
- No need to integrate different workplace cultures and processes, as nothing changes.
So why doesn’t every company have an ESOP?
If ESOPs are so awesome, you’d think every company would want one. Unfortunately, simply wanting one isn’t enough. Some companies may not have the resources or structure needed to succeed as an ESOP. Common reasons a company might opt for a business transition that does not involve employee ownership:
- Company is too small – Costs of administering the ESOP could outweigh benefits
- Earnings are too volatile – Company can’t support the year-round financial needs of an ESOP
- Insufficient working capital – Company is unable to fund or finance the share purchase
- High employee turnover – Staff don’t stay long enough to benefit from the ESOP, leading to high admin cost and minimal culture impact
- A better offer – A business owner might be able to make more money selling externally (to private equity or a competitor) versus selling to an ESOP.
History of ESOPs
Employee ownership existed long before employee stock ownership plans became a thing. As far back as the 1800s, Americans were creating worker co-ops and profit-sharing plans.
ESOPs were first formally recognized and codified under federal law by ERISA, the Employee Retirement Income Security Act of 1974. More than 50 years later, it is still the primary piece of legislation governing retirement plans in the United States today.
Common ESOP Misconceptions
ESOPs are only for large companies
The typical ESOP company typically employs about 20 –150 workers. Companies worth approximately $10M – $100M are often considered prime candidates, although there are many successful ESOP companies outside that range (higher and lower).
ESOP employees control the company
Though employee-owners gain an indirect ownership stake in the company entitling them to the economic value of their stock, ownership interest does not typically come with additional rights or abilities to influence corporate policies, strategies, or decisions beyond what they had before the ESOP was put in place.
ESOPs create too much risk for employees
Though ESOPs only hold a single company stock, rather than a diverse series of investments like a different retirement plan might, failure rates for ESOP companies are lower than traditional firms. Additionally, ESOPs are still governed and backed by ERISA and subject to Department of Labor oversight, which means employees have legal recourse in the event the plan is mismanaged.
ESOPs pay less than fair market value
An ESOP can pay up to fair market value when purchasing a company, but not more.
Frequent Asked Questions About ESOPs
How do employees buy the company stock?
They don’t. Employees do not contribute their own funds to an ESOP, only the time and effort associated with their day-to-day role. The company is responsible for financing the ESOP’s acquisition of stock.
Where do the shares allocated to employees come from?
In most cases, the company borrows money from a bank and/or the selling shareholder in order to finance the purchase of company shares on employees’ behalf.
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