What Is an ESOP? (With Advantages, Disadvantages, and Types)

By Indeed Editorial Team

Published August 17, 2021

ESOPs, or employee stock ownership plans, are a type of business program that appears as investment opportunities, compensations, or incentives for employees. The primary purpose of an ESOP is that it allows an employee to own part of a company. You can make more informed decisions about the ESOPs provided to you by understanding the pros and cons of this type of employee ownership and payment. In this article, we explain what ESOPs are and discuss how they works, the advantages and disadvantages of having them, and the different types of employee stock ownership plans.

What is an ESOP?

An employee stock ownership plan, sometimes called employee share ownership, is a benefit plan that gives employees ownership, or shares, in the company where they work. A share in a company means that they own a unit of capital, or a piece of the company's profits and assets. Owning shares in a company indicates that you're a partial owner of the company. Employee stock ownership plans can align employee interests with the interest of the shareholders. If an employee is a shareholder, they may work harder to contribute to the success of the company.

You might also be able to use ESOPs like you would a Registered Retirement Savings Plan (RRSP). ESOPs help streamline the culture of a company by bringing attention to the work performance of their employees and providing them with incentives to work productively in the interest of their employer.

Related: How To Learn More About a Company's Culture

How do employee stock ownership plans work?

An ESOP has a contribution plan that clearly defines the benefits offered to employees, sellers, and corporations. They are a primary form of ownership for employees and encourage them to behave, act, and think like an owner does to help the business reach success. Companies can use an employee share ownership plan to:

  • offer a lucrative market for the shares of departing owners

  • motivate employees and improve their morale

  • reward employees for their commitment and performance

  • use incentives to gain assets

  • use pre-tax dollars

  • borrow funds at a lower cost after taxes

  • make contributions to employees

You can use an ESOP to purchase or obtain stock from the company and then hold it for employees at no expense to them. Fundamentally, employee stock ownership plans work by:

  1. Creating a trust: The trust is a type of legal entity used to hold the employee's stock on their behalf.

  2. Contributing or borrowing money: The company that an employee works for can add money to their trust or borrow it from an external financial source. When a company borrows money from a seller or bank, it's called leveraged ESOP, and it's a very common practice that companies and organizations use for these types of plans.

  3. Purchasing company shares: By using the money that was borrowed or contributed, the trust buys a specific amount of shares from the company. An independent or contracted appraiser sets the price for these shares.

  4. Distributing company shares: The company distributes shares equally between the employee accounts, but if they're using a leveraged account instead, they allocate the shares as the loan is being paid off. After this, the employee officially becomes a part owner of the company.

Related: How Much Do Investment Bankers Make?

Advantages of ESOPs

There are many advantages to ESOPs, including:

  • Flexibility: Shareholders have the option of withdrawing funds slowly over time or only selling a portion of their shares. They can stay active even after releasing their portion of the company. Additionally, if an employee retires or leaves the company, they can opt to retain their shares, giving them a voice in the company even after they depart.

  • Confidentiality: ESOPs don't share employee information. This means that members' data remains confidential and secure. ESOPs' terms and conditions are fair with no hidden fine print, and they support employees when they need it most.

  • Simplicity: ESOPs offer ease in transfer, which makes them a great option for retirement planning. They provide employees with the opportunity to have a stake in the company for as long as they want, and they can even sell portions back to the company if desired. Owners can reward employees with a portion of the business, incentivizing payment and production. Employee productivity increases, as does the quality of company culture. The company can then repurchase shares and continue to support employees throughout retirement.

  • Consistency in leadership: There may be stronger employee and management retention, resulting in continuity, lower turnover, and vested interest in company success. Employees are well-informed on company success, can have voting rights, and receive updates on plan descriptions and annual statements. These forms of communication function to align the interests of all within the company to enable focus. Company culture drives everyone toward a common goal, creating a positive atmosphere and work environment.

  • Beneficial for employees: When a company offers ESOPs to their employees, it's likely to reduce the turnover of employees, which can provide greater job security and better employee retention. Companies that demonstrate an invested interest in their employees see productivity levels increase, which ultimately helps the company gain more profits and grow at a quicker pace. This might also help them find and recruit candidates that are highly skilled. Generally, you can make investments before taxes and enjoy tax-deductible ESOP payments. ESOPs are tax-exempt trusts, and the longer funds remain, interest compounds, which increases cash flow.

Related: What Are Business Ethics? Definition, Overview, and Examples

Disadvantages of ESOPs

As with most incentive and wage plans, there can be obstacles to getting ESOPs. Here are some of the potential challenges associated with ESOPs:

  • Price per share has limitations: Price per share is dependent upon the company's performance. Without viable profits, the value of the company decreases, which means the value of shares may fluctuate. ESOPs are most beneficial to employees with companies that have an established management plan, producing predictable and consistent financial results.

  • Timing: In order to get the most value from ESOPs, employees may have to time their exit based on company performance. Exiting the company when the stock value is lower will result in a lower payout. Therefore, it's important to consider timing when deciding when to sell shares.

  • Share values are inconsistent: The value fluctuates with company success, and this can make planning for retirement challenging. Because of this inconsistency, if you have ESOPs for retirement, you may need to consider exploring other options in addition to this plan to ensure financial stability, such as a Registered Retirment Savings Plan (RRSP) or Tax-Free Savings Account (TFSA). These plans serve as additional income for individuals who hold ESOPs and are unsure or unable to predict the total value upon retirement.

Types of employee stock ownership plans

Here are some types of ESOP programs and plans:

Direct-purchase programs

A direct-purchase program allows an individual or employee to purchase stock directly from their company. This means they can do so without the need of a broker. Some companies offer this to their employees directly, while others may only offer this through a third-party administrator that handles and manages all the transactions.

Stock options plan

A stock option allows an employee to buy and sell their stocks at an agreed-upon price and date. Options essentially work like bets that you place, and there are two types to consider: puts and calls. A put is when you place a bet on a stock that you expect to fall, and a call when you bet on stock that you expect to rise.

Restricted stock plan

A restricted stock describes company ownership shares that are unregistered and issued by corporate affiliates, like a director or executive. Because you cannot transfer a restricted stock, a trade must occur through compliance with the securities regulators located within the different provinces and territories. These securities regulators generally work in tandem with one another and form the Canadian Securities Administrators, or CSA. These restrictions serve to minimize any premature selling that could negative impact the company.

Related: Guide: How To Become a Stockbroker

Phantom stock plan

A phantom stock plan, sometimes called a shadow stock, is a plan that offers specific employees within senior management the benefits of stock ownership. However, the company doesn't need to provide them with any company stock for them to reap the rewards. Instead of giving these upper management employees physical stock, they give them mock stock. Though this stock is simulated, it abides by the same price movements that are commonly associated with real stock. This allows them to pay out any profits that they gain.

Please note that none of the companies mentioned in this article are affiliated with Indeed.

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