What Is an Employee Stock Ownership Plan (ESOP)?

An employee stock ownership plan (ESOP) is an employee benefit plan that gives workers ownership interest in the company. ESOPs give the sponsoring company, the selling shareholder, and participants receive various tax benefits, making them qualified plans. Companies often use ESOPs as a corporate-finance strategy to align the interests of their聽employees with those of their聽shareholders.

Key Takeaways

  • An employee stock ownership plan gives workers ownership interest in the company.
  • ESOP is usually formed to allow employees the opportunity to buy stock in a closely held company to facilitate succession planning.
  • ESOPs encourage employees to do what's best for shareholders since the employees themselves are shareholders and provide companies with tax benefits, thus incentivizing owners to offer them to employees.
  • Companies typically tie distributions from the plan to vesting.

Understanding Employee Stock Ownership Plans (ESOP)

An ESOP is usually formed to facilitate succession planning in a closely held company by allowing employees the opportunity to buy stock. ESOPs are set up as trust funds and can be funded by companies putting newly issued shares into them, putting cash in to buy existing company shares, or borrowing money through the entity to buy company shares. ESOPs are used by companies of all sizes including a number of large publicly traded corporations.

Since ESOP shares are part of the employees' remuneration package, companies can use聽ESOPs聽to keep plan participants focused on corporate performance and share price appreciation. By giving plan participants an interest in seeing the company's stock perform well, these plans supposedly聽encourage participants to do what's best for shareholders, since the participants themselves are shareholders.

Upfront Costs and Distributions

Companies often provide employees with such ownership with no upfront costs. The company may hold the provided shares in a trust for safety and growth until the employee retires or resigns from the company. Companies typically tie distributions from the plan to vesting鈥攖he proportion of shares earned for each year of service.

After becoming聽fully vested,聽the company "purchases" the vested shares from the retiring or resigning employee. The money from the purchase goes to the employee聽in a lump sum or equal periodic payments, depending on the plan. Once the company purchases the shares聽and pays聽the employee, the company redistributes or voids the shares. Employees who resign聽or retire聽cannot take the shares of stock with them, only the cash payment. Fired employees often only qualify for the amount they have vested in the plan.

Employee-owned corporations are companies with majority holdings held by their own employees. These organizers are like cooperatives, except that the company does not distribute its capital聽equally. Many of these companies only provide voting rights to particular shareholders. Companies may also give senior employees聽the benefit of more shares compared to new employees.

ESOP and Other Forms of Employee Ownership

Stock ownership plans provide packages that act as additional benefits for employees to prevent hostility and keep a specific corporate culture that company managements want to maintain.

Other versions of employee ownership include direct-purchase programs, stock options, restricted stock, phantom stock,聽and stock appreciation rights.聽Direct-purchase plans let employees purchase shares of their respective companies with their personal after-tax money. Some countries provide special tax-qualified plans that let employees purchase company stock聽at discounted prices.聽

Restricted Stock, Stock Options, and Phantom Stock

Restricted stock gives the employees the right to receive shares as a gift or聽a purchased item after meeting particular restrictions, such as working for a specific period or hitting specific performance targets.聽Stock options provide employees with the opportunity to buy shares at a fixed price for a set period, while phantom stock provides cash bonuses for good employee performance.

These bonuses equate to the value of a particular number of shares.聽Stock appreciation rights give employees the right to raise the value of an assigned number of shares. Companies usually pay these shares in cash.