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Answers to Common Questions About ESOPs

Employee stock ownership plans (ESOPs) can have many benefits for business owners, shareholders, and employees. However, there is no doubt that they can be complex, and they are not right for every company. To help you determine whether ESOPs are right for your business, we created this blog post that has answers to many ESOP FAQs.

What Is an ESOP?

ESOP stands for employee stock ownership plan. An ESOP is an employee benefit plan that grants employees stock within the company. It’s often used as a way to reward employees and align them with overall company objectives. It can also be a great succession planning strategy for owners of privately held businesses.

What Are the Advantages of ESOPs?

One of the primary advantages of ESOPs is that they can motivate employees, as their financial success is tied to the success of the company. 

For the business owner and shareholders, ESOPs can provide a flexible exit strategy that doesn’t require a third-party buyer.

What Are the Disadvantages of ESOPs?

The primary disadvantages of ESOPs are the upfront and ongoing costs. This includes consulting a third-party firm to help you set up the ESOP and annual valuations by an independent appraiser, among other administrative and legal costs.

Another disadvantage is that ESOPs can hurt cash flow since there's an obligation to purchase shares from participants that terminate their employment.

How Are ESOPs Used as an Exit Strategy?

ESOPs are often used as an exit strategy for business owners and shareholders of small to medium-sized businesses (SMBs). Finding a third-party buyer for SMBs can be difficult, and ESOPs provide a flexible option to exit the company. On top of this, it allows employees to retain control of the company, instead of passing control over to a third party.

To do this, the ESOP trust purchases the stock from the shareholders. If the company cannot buy out the shareholder or business owner on its own, those shares can be purchased at fair market value by the ESOP trust through a loan that the company makes to the ESOP.  The ESOP will then repay the loan as the company makes the contributions to the ESOP.

How Do ESOPs Work?

When a company puts an ESOP in place, it sets up a trust. Through this trust, the company can purchase shares from the owner or the company can issue new shares into that trust. The ESOP trust can also purchase shares from the company through a loan that it will pay back over time. The important aspect of all of this is that shares must be bought at the fair market value of the company stock.

In general, all employees after age 21 and who meet the service requirement, can participate in the ESOP and are allocated shares from within the ESOP trust. As employees work for the company, they become vested in the shares allocated to them. 

How Are ESOP Shares Allocated?

ESOP shares are usually allocated based on employee compensation. Once the shares are allocated, employees become vested in those shares as they work for the company. Vesting for ESOPs is usually gradual, with employees becoming more vested in their allocated shares over time. Here’s an example:

  • Employee works with company for one year - 25% vested
  • Employee works with company for two years - 50% vested
  • Employee works with company for three years - 75% vested
  • Employee works with company for four years - 100% vested

When an employee leaves the company, the company purchases their shares at the employee’s vested percentage.

What Retirement Plan Options Can Companies With ESOPs Offer Employees?

Companies with ESOPs can still offer many of the benefits offered by other companies, including:

  • 401(k) plans
  • Safe harbor 401(k) plans
  • Pension plans
  • Profit sharing

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Michelle Buckley is a Vice President in Meaden & Moore’s Assurance Services Group with 23 years of public accounting experience.

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