What Is an ESOP?

Is an ESOP a Gift to Hard-Working, Loyal Employees?

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Employee stock ownership plans (or ESOPs) are a popular benefit that many companies offer to their employees. Owning a share of the company without personal cost is one of the many perks associated with long-term employment, but just like any investment, it does have risks.

What is an ESOP?

An ESOP or Employee Stock Ownership Plan is a benefit or retirement-type plan for employees of a company.

  • Employees receive regular shares of the company’s stock as a benefit for working at the company.
  • All employees are eligible to participate in the ESOP after a certain period of time employed. Depending on the plan, this is around one to two years after they're hired.
  • The number of shares offered to each employee is determined by a formula set up by the company. It could be based on pay-scale, time on the job, or similar factors.

A Gift to Employees

Most frequently, the ESOP is formed to provide an opportunity for the owners of a closely held, private, successful company to obtain liquidity for a portion of the shares that they own in the firm. In some cases, the ESOP allows the company to borrow money to purchase property or other assets using pre-tax dollars, too.

The shares are priced conservatively based on the cash flow of the business, so it is a low valuation of the actual value of the firm. This makes the ESOP a gift from the shareholders to their employees which is why the media often announce ESOPs by saying that the employer 'gave the company to its employees.'

An Incentive for Good Performance

A second reason why owners establish ESOPs is that it motivates and rewards employees. After all, the hard work of a company's employees contributes significantly to the past and continued growth and success of the business.

The True Value of an ESOP

When you consider an ESOP from the point of view of the company owners, you must recognize that the company will be valued at a higher selling price by almost any other method of determining value.

For example, selling the company would bring shareholders whatever the market will bear in most instances. This means that a successful company, sold to the highest bidder, could bring the owners 10, 20 or more times the valuation that is given for an ESOP.

This approach would cause disruption for the employees if the purchasing company or individual decided to move the business, merge the company with another business, layoff redundant employees, and so forth. The ESOP provides the most stability for employees as long as the company remains successful.

What Happens to ESOPs at the End of Employment?

Most significant for employees, they receive shares in the ESOP without paying for them. When employees leave the company or decide to retire, they receive their stock. The company is then required, in turn, to buy back the stock from the employee at fair market value.

  • If the company has gone public, the stock price determines the value.
  • The company has up to five years within which to make this purchase.