What is an employee stock ownership plan (ESOP)?

Many companies use equity incentives to attract and retain talent. And for good reason, since they’re also a useful driver of performance. 

In fact, in a recent study of workplace benefits, 84% of employers and 97% of HR leaders said that stock-based compensation is the most effective way to keep employees engaged and motivated.

But how exactly do employee stock ownership plans (ESOPs) work? Who's eligible to take part? And are they the most suitable type of equity incentive?

In this article, we'll cover all the information you need, including how an ESOP works, how to set one up, and what you need to consider.

What is an ESOP?

An ESOP is a program that allows employees to own shares in your company, usually after a set period of time.

From a benefits perspective, it is often used as a retirement plan that provides your people with a stake in the business, aligning their interests with your company's success.

What is the difference between an ESOP and stock options?

It's crucial to understand the difference between setting up an ESOP, and offering stock options (i.e., an equity incentives plan).

In an ESOP, employees do not generally pay anything for the shares they receive. They are also, as mentioned, designed to be used as a retirement fund.

However, with stock options, recipients are typically given the option to purchase the shares at a fixed price (known as the exercise price). If the market value of the shares is higher than the exercise price, your employees can then sell their shares and pocket the profit. As a result, it's more of a short-term incentive.

In the US, there is some confusion around these terms, with many people referring to ESOPs when they actually mean an equity incentives plan (and vice versa). Therefore, it's important to be aware of the difference.

To learn more about offering stock options instead, check out our in-depth guide.

How do ESOPs work?

Creating and operating an ESOP involves several steps, as follows:

1. Establishment of an ESOP trust

An ESOP trust is responsible for holding and managing the portion of your company’s shares that are designated for employee ownership. Typically, this trust is a separate legal entity, which helps ensure that your employee shares are kept distinct from your other company assets.

Once the ESOP trust is established, it serves as the “pool” from which employee shares are gradually allocated.

This initial phase often involves:

• Legal structuring. You must work with in-house or external legal professionals to ensure that your ESOP trust complies with your country's tax regulations.

• Financing the trust. You can fund your ESOP trust in one of two ways: through cash contributions to purchase shares from existing owners, or by issuing new shares directly into the ESOP.

2. Contribution of shares

Once the trust is in place, your company can begin contributing shares. These shares can be sourced in several ways, such as:

• Direct share contribution. Your company allocates shares directly to the trust, gradually increasing employee ownership at no additional cost to your employees.

• Borrowing funds to buy shares. Companies often borrow funds to buy shares from existing owners, allowing your company's primary shareholders to begin selling their shares in a structured way. This is known as a “leveraged ESOP,” and is common for companies aiming to facilitate a gradual ownership transition.

In both scenarios, your company makes annual contributions to the trust, either as new shares or cash, which the ESOP uses to buy shares. Note that, in many cases, these contributions are tax-deductible, providing substantial tax advantages for your business.

3. Allocation of shares to employees

As shares accumulate in the ESOP trust, they are allocated to individual employee accounts based on criteria like years of service (or other performance-based conditions). Allocation typically occurs annually, providing employees with growing ownership stakes as they remain with the company.

To encourage retention, ESOPs often employ a vesting schedule. This determines how long your employees must stay with your company to gain full ownership of their shares. A common vesting schedule, for instance, is four years.

Depending on the structure of your ESOP, your employees can then opt to either keep or sell their shares, usually back to your business. This ensures continuity for the scheme.

What are the benefits of ESOPs?

ESOPs provide financial and cultural benefits for both your business and your employees, particularly in small businesses where employee involvement is critical to growth.

These benefits can include:

1. Enhanced recruitment and retention

ESOPs give your employees the potential to build wealth through equity, turning workers into owners with a vested interest in company performance. This is a hugely attractive prospect for potential hires, enabling you to boost your recruitment efforts.

It also gives your existing employees a financial stake in your company. As a result, they are more likely to stay longer, reducing turnover and the costs associated with constant hiring.

2. Tax advantages

Depending on the tax rules of your country and the structure of your ESOP, you may receive significant tax benefits. Contributions to the ESOP trust may be tax-deductible, reducing your company’s overall tax burden.

In the US, for example, companies structured as an S corporation can potentially eliminate federal income taxes on the ESOP-owned portion, creating substantial tax savings and reinvestment potential.

3. Smoother succession planning

An oft-overlooked benefit of ESOPs is that they can serve as a useful succession tool, especially for small business owners who are looking to retire or transfer ownership gradually (rather than selling to a third party). ESOPs provide a way to do this, enabling owners to sell shares internally and preserve the company’s culture and legacy.

Unlike external buyouts, ESOPs maintain continuity, avoiding the business upheavals that can come with new ownership.

What are the main challenges of ESOPs?

While ESOPs offer many advantages, they come with some considerations that small business owners especially should understand. For instance, setting up and maintaining an ESOP can be complex and costly. From legal fees to ongoing valuations, your business needs to budget for these administrative costs.

For existing owners, an ESOP also means relinquishing a portion of ownership, which might not suit all business strategies.

ESOPs vs other equity incentives

When evaluating your equity incentive options, ESOPs aren’t the only choice. Here’s how they compare to other equity plans:

Not every business will benefit from an ESOP, so before you do anything, it’s crucial to evaluate your goals, finances, and long-term growth strategy.

Our Remote Equity experts can help you identify whether an ESOP is the right approach for your company, or whether offering stock options may be a more suitable choice.

If you do opt for an ESOP, it's also highly recommended to consult with a dedicated ESOP specialist who can offer tailored advice.

How can Remote help?

As mentioned, our in-house experts can help you make an informed decision around equity incentives, and help ensure that your company can reap the rewards of an equity incentives scheme without having to worry about compliance, tax laws, and other complexities.

This is particularly useful if you have employees in different countries, where the complexities can increase tenfold.

To learn more about offering equity incentives, including which is the right approach for your business, speak to one of our friendly experts today.

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