ESOP - What is it, How Does it Work?
An employee stock ownership plan (ESOP) is an employee benefit plan that gives workers ownership interest in the company in the form of shares of stock.
KEY TAKEAWAYS
- An employee stock ownership plan (ESOP) is an employee benefit plan that gives workers ownership interest in the company in the form of shares of stock.
- ESOPs encourage employees to give their all as the company’s success translates into financial rewards.
- They also help staff to feel more appreciated and better compensated for the work they do.
- Companies typically tie distributions from the plan to vesting, which gives employees rights to employer-provided assets over time.
- It’s important to read the terms of your ESOP, as each one may vary and have different rules.
- Other versions of employee ownership include direct-purchase programs, stock options, restricted stock, phantom stock, and stock appreciation rights.
How Does an Employee Stock Ownership Plan (ESOP) Work?
An ESOP is usually formed to facilitate succession planning in a closely held company by allowing employees to buy corporate stock shares.
ESOPs are set up as trust funds. They 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 several large publicly traded corporations. Contrary to what some people say, companies with an ESOP must not discriminate and must appoint a trustee to act as the plan fiduciary. Among other things, it is not possible for senior employees to receive more shares or for ESOP participants to have no voting rights.
Advantages of ESOPs
Since ESOP shares are part of the employees’ remuneration package, companies can use ESOPs 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 encourage participants to do what’s best for shareholders, since the participants themselves are shareholders.
ESOP and Other Forms of Employee Ownership
Stock ownership plans provide packages that act as additional employee benefits and embody the corporate culture that company managements want to maintain. Other versions of employee ownership include direct-purchase programs, stock options, restricted stock, phantom stock, and stock appreciation rights.
- Direct stock purchase plan (DSPP) lets 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 at discounted prices.
- Restricted stock gives employees the right to receive shares as a gift or a purchased item after meeting particular restrictions, such as working for a specific period or hitting specific performance targets.
- Stock options allow employees to buy shares at a fixed price for a set period.
- Phantom stock provides cash bonuses for good employee performance. These bonuses equate to the value of a particular number of shares.
- Stock appreciation rights give employees the right to raise the value of an assigned number of shares. Companies usually pay these shares in cash.
The Bottom Line
ESOPs are generally a win-win for employers and employees, encouraging greater effort and commitment in exchange for bigger financial rewards. However, they are not always straightforward and can be frustrating if the participant doesn’t fully understand the terms of their particular plan.
Not all ESOPs are the same. Rules on actions such as vesting and withdrawals can vary, and it’s important to be aware of them to make the most of this benefit and not potentially miss out on a big extra bonus.
Brett Andrews
Value Building &
Exit planning expert
Exit planning expert
Tara Groody
Business Analyst &
Operations Expert
Operations Expert
Rebecca Andrews
Protection/Risk Analyst &
Insurance expert
Insurance expert
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