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What Is an ESOP?

May 15, 2017

As baby boomers continue to age into retirement, the topic of transition planning becomes central to many businesses. Some company owners plan for a sale to a third party, while others close up shop entirely. And many, of course, plan to keep ownership in-house.

If you've spent more than a few years involved in business management, finance, or strategy, the chances are good that you're familiar with the concept of employee stock ownership plans, or ESOPs. While not entirely common, plenty of companies use this kind of benefit plan to effectively prepare for the future.

However, the ins and outs aren't quite as straightforward as they sound. So, the question remains: what is an ESOP plan, really?

What Is an ESOP?

As the name states, an ESOP is an employee stock ownership plan. Technically, it is a qualified deferred benefit plan, in which employees receive shares of stock that can then be sold upon termination, departure, or retirement.

In essence, this plan allows for the sale of company stock from an owner or group of owners to qualifying employees rather than a third party, effectively maintaining the integrity of a business organization. This provides a vehicle for company owners to receive compensation equal to the fair market value of the business while still continuing on in a role within the company if so desired.

For employees, an ESOP offers an additional perk to employment, providing a reason to stay focused on a communal goal. For employers, an ESOP can keep productivity and morale high while simplifying the process of transitioning ownership.

How Does an ESOP Work?

The basic structure of an ESOP is not overly complicated. Essentially, an ESOP allows a company's ownership to sell stock to a trust that can then allocate stock holdings to employees as a form of a retirement benefit in exchange for liquid capital. The stock doesn't have to be sold in full, either; many owners maintain at least partial ownership interest until full retirement is desired.

To implement an ESOP, a company first establishes a trust and then sells stock shares to the trust. These shares are then distributed based on factors like employee eligibility, firm tenure, and compensation, depending on the desired policy. Individual allocations of the stock can begin as soon as an employee joins a firm, or after a period of time passes, like two years of service. As with standard retirement account contributions, these shares must vest before becoming accessible to an employee. Generally, vesting occurs over a three to five-year period. Once stock-holding employees leave the firm, they must sell back all shares for a cash equivalent. These shares can then be voided or absorbed back into the plan to be redistributed later.

As a form of ownership vehicle, ESOPs do have voting rights within a company. However, these rights are not held by each participant, but rather by the plan's trustee. This allows owners who are seeking a transition plan a way to maintain control while still ultimately surrendering ownership.

The Best Candidates for an ESOP

ESOPs, despite their advantages, aren't right for everyone. Successful candidacy is industry-specific as well as company-specific, although any willing company that meets the eligibility criteria can participate. The most common candidates are privately traded and small in size (revenues > $5 million but < $1 billion) with an effective, goal-driven management team. Close-knit companies often have the best chances of success; in a smaller organization with a tight-knit culture, long-term loyalty, and regular operations, employees are much more likely stay dedicated to a business plan.

As a general rule of thumb, companies that are best suited for ESOPs have steady cash flows guaranteeing enough capital to support formation and plan expenses. This also includes CPA prepared financial statements and at least one independent director, providing an unbiased, accurate platform upon which to move forward.

However, many of these points are negotiable and success doesn't hinge on size or structure. A large company with a team-oriented culture can create a plan that is just as effective as one maintained by a smaller company with a similar management style. At the end of the day, corporate objectives and atmosphere can mean as much or more as other suggested criteria,

Establishing an ESOP can be a positive strategic decision for companies of all shapes and sizes, offering a mutually beneficial structure for both owners and employees. Providing a simple way to help a company change hands without interrupting operations, the right ESOP setup can be an extremely valuable tool.

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Gary Canon

Written by Gary Canon

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