There are plenty of ways that a company can choose to reward its employees while being cost efficient. One of them is the Employee Stock Ownership Plan. The ESOP allows employees to receive work compensations and free beneficial ownership of the company. But let’s take this definition a bit further. What is an ESOP and how does it work?
First, let’s take a look at some numbers about the Employee Stock Ownership Plan and see why it might sound tempting for a significant number of private companies.
- Companies that choose ESOP grow with 2,3% – 2,4% after setting up the plan, according to a Rutgers study developed in 2000.
- There were around 6,717 ESOP companies in the US in 2014. Their assets were worth over $1,3 million. Less than 10% of them are public firms. Most of the private companies who use ESOP are in manufacturing, technical services, and real estate.
- The average ESOP employee received around $4,443/year in 2008 and had an account balance of $55,836. This amount constists of company contributions to the ESOP, and it is tax deductible.
What Is an ESOP?
The above numbers are the results of a plant invented back in 1956. It later flourished as a qualified pension plan for employees with no tax included. The company sells or loans shares to the ESOP trust, but the employee does not need to pay for the shares and benefits. So, what is an ESOP and how does the company sets it up?
The ESOP begins when the company creates a trust into which it makes annual tax-deductible contributions, within limits. The amounts go to an employee’s account after the firm allocates it as an annual benefit for the work. You can see this as an employee benefit plan. However, most of the employees choose to treat these amounts as retirement savings. The primary purpose of the ESOP is to strengthen the interest of employees towards the company and its performance. This is all made at no cost to the employee.
Who Uses an ESOP?
There are no specific limits to companies who wish to engage in setting up an ESOP. Information is available to all companies who wish to know what is an ESOP and how to develop the plan. After setting the plan, the company needs to make sure that all full-time employees over 21 (where there are no exceptions mentioned) participate in the plan. The rights of the employees grow with their experience within the company. So within 3 – 6 years they should be fully vested. The company receives the stock back at market value when the employee leaves it or retires.
There are no specific limits that a company needs to pass in order to qualify for setting up an ESOP. However, the company then becomes employee-owned, and its owners have some extra rights than in other institutions. Here are some of them.
- Senior employees may receive more shares than the average ones;
- In private companies, they may have the right to vote when it comes to major decisions such as relocation. However, in public companies this vote is mandatory;
- Since it is based on shares, it is not hard to ask ourselves what is an ESOP returning in case it fails? When participating, the employee shares the success and risk with the owner. So, there is not a certain amount guaranteed for the employer, but there is the safety of a free benefit.
How to Create a Promising ESOP for Your Company?
Now we have already figured what is an ESOP. But let’s see what you can do to increase the safety of an ESOP plan.
- First, make sure that your company is large and stable enough to justify and sustain the costs of setting up an Employee Stock Ownership Plan.
- Understand the terms used in order to realize what is an ESOP and what it involves. See the particularities, such as the tax application to dividends. You can even hire a company to explain the applicability of these terms to your firm.
- Conduct feasibility studies to estimate where it can lead to for your and your employees.
- Hire a business attorney to make sure that you are developing the plan accordingly.
- Plan the costs of the ESOP step-by-step. You may choose a leveraged transaction, which means that the company loans the trust with funds. This amount is usually around $125,000 – $250,000.
- Finally, develop the plan.
3 Tips to Fully Benefit From an ESOP
1. Train Your Employees
It is important for your employees to know all the aspects of the ESOP and all of its implications. Make sure that they understand how and when they receive the allocations, how the shares return to the company and which are the chances they take.
The ESOP is by itself an opportunity for the company to have employees which are directly interested in being productive and who truly get involved in the evolution of the company. Make sure that they are aware of all these aspects; including the risks that the shares bare.
2. Establish the Overall Purpose of the ESOP
One of the purposes of an ESOP is also to buy out shares from a former owner or even to have the ESOP borrow money when these are necessary. Even if the trust is mostly for employee benefit, you need to make sure what the ESOP is useful for when needed.
It is also important for you to be fully aware of all the tax deductions and deferrals for future calculations.
3. Set Up the Process of Offering Shares
Technically, you are inviting the employees to participate in an ESOP as a bonus. Since it includes a long-term plan, you can also decide on what criteria you offer the allocations annually. A common practice, in this case, is the employee appraisal. The amount increases along with worker experience within the company. So the reward should also reflect higher productivity.
Knowing What Is an ESOP
Now you have seen the basics of what is an ESOP and what impact it may have on your company. You may decide on a transition to such a plan for your company. In this case, get the best advice in the field and make the most out of it!
Have you already set up an ESOP within your company? Share your experience with us!
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