What it means
In a typical ESOP, the company sets up a trust, and the trust holds shares for the benefit of employees. The company funds the trust either by contributing new shares or cash, or by having the trust borrow money to buy shares from the owners.
Employees do not pay for the shares, and their accounts are credited as they work for the business. There are two common structures.
In a non-leveraged ESOP, the company simply contributes shares or cash to the trust each year. In a leveraged ESOP, the trust borrows to buy a large block of shares at once, and the company makes annual contributions that the trust uses to repay the loan, releasing shares to employee accounts as the debt is paid down.
ESOPs are popular for succession planning. The founder of a private company who wants to retire can sell shares to the ESOP trust, receive cash and see the business stay independent, owned by the people who built it.
Tax rules in some countries, including generous deductions for contributions, make this route attractive, though the details change and need specialist advice. Allocation rules decide who gets what.
Shares are commonly allocated to employee accounts in proportion to pay, and employees become entitled to them over a vesting period, which means they must stay for a set time to keep their balance. When someone leaves, the company usually has to buy back their shares at fair value, which is a cash obligation that must be planned for.
From an accounting point of view, the company records compensation expense as shares are released or contributions are made. Leveraged ESOPs also raise questions about how the trust's debt is shown in the accounts.
The rules are technical, so finance teams work closely with their auditors. The main risk for employees is concentration.
Their jobs and their retirement savings depend on the same company, so a downturn can hurt twice. For this reason, ESOPs are normally one part of a broader benefits package, not the only retirement saving employees have.
In practice
Real-world examples
Example 1
The founder of a 150-person engineering firm wants to retire but does not want to sell to a competitor. The company sets up an ESOP, which borrows from a bank to buy 40% of the shares from the founder. The employees gain a stake and the founder receives cash.
Example 2
A distribution company contributes $300,000 of new shares to its ESOP each year instead of paying a cash bonus. The shares are allocated to staff in proportion to pay. The finance director records the contribution as compensation expense in the year it is made.
Example 3
A manufacturer's long-serving machinist retires after 25 years with an ESOP balance of 6,000 shares. An independent valuation puts the shares at $18 each, so the company pays her $108,000 for her stake. The finance team planned this cash outflow in its forecast.
Think of it
An ESOP lets employees own company stock through their retirement plan-workers become owners.
Formula
Calculation
Shares released each year = Total shares held by the trust x (Debt repaid this year / Total debt at the start)
Employee allocation = Shares released x (Employee pay / Total pay of all participants)
Suppose a leveraged ESOP borrows $2,000,000 to buy 100,000 shares at $20 each, and repays $200,000 of the loan in the first year.
Shares released = 100,000 x (200,000 / 2,000,000) = 100,000 x 10% = 10,000 shares, worth 10,000 x 20 = $200,000.
An employee whose pay is 1% of total participant pay receives 10,000 x 1% = 100 shares.
At $20 per share, the employee's allocation is worth 100 x 20 = $2,000 for the year.Case study
Seen in the real world
Stonebridge Construction is an illustrative, fictional company owned by a single founder who wanted to retire within five years. Offers from larger competitors would have meant redundancies for the 200 staff.
The company created an ESOP, which borrowed $4,000,000 to buy 30% of the shares from the founder. Each year the company contributed about $500,000 so the trust could repay the loan, and shares were released to employee accounts in proportion to pay.
The finance director also set aside a reserve to buy back shares from departing employees, since a rising share price increased that obligation. The illustrative lesson is that an ESOP can solve a succession problem, but only if the cash needed for repurchases is planned in advance.
Watch out
Common mistakes
- Assuming employees pay for their ESOP shares, when the company or the trust funds them.
- Ignoring the future repurchase obligation, which can become a large cash demand as the share price and the number of leavers rise.
- Relying on the ESOP as the only retirement saving, which concentrates employees' risk in one company.
Questions
People also ask
What is the difference between an ESOP and employee share options?
An ESOP is a trust that holds shares for staff at no cost to them, while options give staff the right to buy shares at a set price later.
Who sets the value of ESOP shares in a private company?
An independent valuer normally determines the fair value each year, because there is no market price to rely on.
Do employees control the company through an ESOP?
Not necessarily, because the trustees vote the shares in most cases, and the extent of any employee voting rights depends on the plan and the law.
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