What is an ESOP? Your Guide to Employee Stock Ownership Plans

As your business grows and you hire more employees, you’ll need a plan to retain your workforce for the future. One benefit you might consider is an employee stock ownership plan (ESOP).

What is an ESOP, and how can it benefit you and your employees? Here’s what you need to know about ESOPs and how to determine if they’re right for your small business.

What is an ESOP?

ESOPs allow you to sell some or all of the ownership in  your business to your employees. There are many perks to offering ESOPs such as:

  • Incentivizing your employees: When you give your employees a vested interest in your business’s success through ownership, their performance improves and they’re more likely to stay with your company. They give your employees an incentive to stay with your business by giving them a vested interest in your business’s success.
  • Creating a retirement plan option: This benefits you and your employees. With an ESOP, your employees have another retirement fund outside of their 401ks. And when you’re ready to retire or move on to a new opportunity the ESOP can give you that option.
  • Tax benefits: Like with other retirement plans, your business can deduct contributions into an ESOP. Talk to your accountant to find out more about how this type of tax deduction could work for your business.

Another benefit is that an ESOP creates a retirement plan option for your employees outside of their 401ks. It also gives you an option to leave your business when you’re deciding to retire or move on to a new opportunity.

What does an ESOP look like in action? Consider this example:

A coffee roaster with $10 million in annual revenues and 45 employees decides to set up an ESOP. Under the ESOP, employees that have been with the business for a set amount of time and senior employees receive company stock worth an average of $15,000 per person. After 10 years, the company’s founders have transferred 60% of the company’s stock to employees through a specialized trust set up to hold their ownership.

At that time the founders decide they want to sell their stake in the company and move on. Valuing their stake in the company is easy because there’s a 10-year history of stock transactions. The employee stock trust then takes out a loan to purchase the remaining stock owned by the founders. A provisional leadership is set up among the employees to continue operations.

How do employee stock ownership programs work?

There are two ways that you can set up an ESOP, but first you’ll need to a separate trust called an employee share ownership trust (ESOT), which holds all your employees’ ownership shares in your business. Your employees are all the beneficiaries of this ESOT and an independent trustee is assigned to administer this trust. Here are your options for setting up an ESOP from there:

  1. Your business can give ownership shares to your employees that your business buys back when an employee retires. During the time they work for your business, your employees will build up ownership shares. When they retire, your business buys back their shares and pays them in cash (usually in a lump sum).
  2. You can give permanent ownership shares to your employees.  During their employment, your employees accrue ownership in your business. Upon retirement, they can decide what to do with their share of the company’s equity.

Keep in mind that ESOPs can be expensive to set up and run.  The cost of setting up an ESOP ranges from $50,000 to $100,000 and maintenance costs can average more than $4,000 per year.

Pros of an ESOP

An ESOP is a flexible and ethical way for you to transition out of your business. It gives you a realistic business valuation since you’re regularly checking in on your equity as your employees earn it.

You could also use an ESOP as part of your business owner retirement plan by transferring your ownership of the business to your employees. You have the option of transferring ownership evenly over the years to employees, or even have the trust borrow money to buy out your remaining stock.

For your employees, an ESOP gives them tax-deferred performance-based benefits. Unlike bonuses, which are taxed when they’re received, stocks received through an ESOP are only taxed when the employee retires and starts to sell those stocks.

Cons of an ESOP

There are some disadvantages for your employees when it comes to an ESOP.  While earning company equity is a great perk, the retirement plan is riskier for employees. That’s because ESOPs aren’t  diversified, meaning they’re not invested in a variety of funds. Most retirement funds and programs have a diversity of investments to lower risks. ESOPs put the full investment in one place, and the returns from owning equity may be substantially lower than other retirement options.

When your employees cash out their ESOP at retirement, they don’t have much control over their tax consequences. Receiving their equity in a lump sum might result in a large tax payment too.

ESOPs can be expensive to maintain and also follow many rules and regulations. For example, making sure that stock is evenly distributed to employees, and no one is favored more than others.

Pursuit can help provide insights into your employee retention strategy

Setting up an ESOP is just one piece of your employee retention strategy, and there are many other benefits you can offer.  Pursuit’s Business Advisory Services team offers expert advice and consulting in human resources and more to help your business reach higher. When you get financing through Pursuit, you’ll get access to these services at no cost to you. Contact us today to learn more about how we can work together to keep your business growing.

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