What Is an ESOP and How Does It Work?

What Is an ESOP and How Does It Work?
RMEOC
March 16, 2021

When you’re wondering what’s next for your business, an ESOP is an important option to consider.

Rather than going about “business as usual,” an ESOP can enable you to cultivate the right kind of relationship to your business, your employees, and your own life.

At their core, ESOPs are a method of promoting employee ownership and receiving all of the benefits that come with it. And as more and more businesses are learning about the advantages they offer, many are turning to ESOP plans as a superior exit strategy in the case of retirement.

After all, you put your heart and soul into your business — so you deserve to enjoy the fruits of your labor. ESOPs make it easier to transition away from the business and see all parties thrive.

But if you’re a little unsure about what an ESOP is, what it entails, and why you might consider it for your own business, we’ve broken it down for you below.

The basic structure of an ESOP

ESOP is an acronym that stands for “employee stock ownership plan,” though we can all admit that it’s way more fun to say “ESOP.”

Ranging in size from companies with 10 or 20 employees to some with tens of thousands, the purpose of any ESOP is to give employees ownership stake in their company without having to invest any of their own money.

In an ESOP, employees become shareholders in the company through a trust that acquires stock and pays out dividends when employees retire or leave the company. It’s a lot like a 401(K), though contributions are made entirely by the company through gifted shares.

Put simply, all or part of a company’s shares are placed in a retirement fund and administered on behalf of employees. Then they get paid when they leave.

The process looks like this:

A company establishes a legal entity that holds stock on behalf of the employees and starts contributing to it through existing or borrowed money.
Typically, employees become eligible to participate in the ESOP by working for a certain period of time and becoming vested in the company.
The company allocates a certain number of shares to each eligible employee. This might be based on pay scale or another form of distribution, but legal regulations require it to be equitable.
Each employee’s shares are held in the company’s ESOP trust until they leave or retire. When that happens, employees can sell their shares on the market or back to the company — and they pay no taxes until the sale.

The process can be a bit more involved depending on the circumstances. For example, an independent appraiser is needed for an ESOP to buy company shares from the selling owners, and “leveraged” ESOPs need to follow additional regulations in order to borrow money from banks.

Examples of ESOPs

ESOPs have become a popular option for promoting equity and ownership among workers.

The Menke Group reports that since 1974, an estimated 22,000 companies have implemented an ESOP, covering over 14 million employees and holding $1.4 trillion in assets.

There are over 120 employee-owned businesses in Colorado alone, many of which are worker cooperatives or traditionally structured firms with ESOPs.

A few well-known companies with ESOPs include:

Publix

King Arthur Flour

Land O’Lakes

Left Hand Brewing

Eileen Fisher

Equal Exchange

In fact, we put together a list of 33 popular brands that are creating equity through ESOPs. What they have in common is that they are all examples of how employee ownership can be used in firms of any industry and size in order to build an economy that works for everyone.

Why Consider an ESOP for Your Business?

ESOPs deliver a myriad of benefits for employees, selling owners, and the company itself. We covered many of these in our post What Are the Benefits of Employee Ownership?

In that post, we cited an NCEO study showing that, compared to workers in traditional firms, workers in employee-owned companies receive a 33% higher median income and have a 92% higher median household wealth. They enjoy greater access to benefits like flexible work schedules, retirement plans, parental leave, and tuition reimbursement, and they stay in stable jobs for nearly 2 years longer.

That might be part of the reason why employee-owned businesses grow faster than their traditionally-owned counterparts.

A report in Harvard Business Review called this “the ESOP effect” when they found that, during the five years after companies instituted ESOP plans, their annual employment and sales growth were each more than 5% faster than their competitors.

Companies with employee ownership also typically see greater productivity, higher profitability, and increased revenue — successes that tend to continue over time. A study cited by GEO found that after five years, 90% of cooperatives are still in business.

Finally, for owners looking to retire or pursue a different path, transitioning to employee-ownership is one of the best exit strategies there is.

Selling the company to employees can provide more stability, predictability, and a smoother transition for the company and its leadership, providing the selling owners with a “built-in buyer” that will carry on the company, preserve jobs, culture, and mission; and remain open for business in the community.

Of course, one of the most significant benefits for all parties involved is the unique tax structure of an ESOP.

The advantage of an ESOP over a 401(K) for employees is that they are able to acquire their stock without paying a current income tax on it. They are only taxed once they begin receiving dividends, and many take advantage of tax-free rollovers to an IRA.

For the company, ESOPs make pre-tax dollars available to finance company growth. Tax deferrals can increase cash flow and give the company a competitive edge, while tax-deductible loans allow them to borrow at a lower rate in order to refinance debt, reinvest in the company, and acquire other businesses, among other things.

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If you’re interested in exploring how a conversion to employee ownership can help your own business take advantage of ESOP plans and promote equity among workers, schedule a free consultation with us.

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