What Are Employee Stock Ownership Plans (ESOPs)?
An Employee Stock Ownership Plan (ESOP) is a retirement benefit plan for employees, like a 401(k), but with some important differences. As opposed to a 401k, an ESOP does not accumulate shares of other companies in plan participant accounts, but instead, it invests primarily in the stock of the employer company. Also, instead of reducing their current salary to build their account value, employees don’t use any of their money to fund ESOP accounts. ESOP employee account value growth comes from the employer’s financial performance, which of course aligns the interests of employee and employer. Finally, an ESOP can borrow money to buy the sponsoring company’s shares directly from selling shareholders or from the company. This is how business owners can use the ESOP to create a liquidity event or an exit strategy.
ESOPs – Mysterious to Most People, but Not New
While most people, even people who are otherwise finance and transaction sophisticated, don’t know much about ESOPs. Employee ownership has been around a long time. An ESOP which is a tax-qualified employee benefit plan designed to invest primarily in employer stock, was written into the tax code in 1921, but the first time an ESOP was used as a tool for business succession was in 1956. The laws creating the tremendous opportunities ESOPs provide to business owners and employees were enacted in 1974 and have remained mostly unchanged since.
Despite existing in their current form since 1974, there are a lot of mystery and misconceptions surrounding ESOPs. We think this is primarily caused by professionals advising on ESOP transactions without the requisite experience. There are definitely right ways and wrong ways to structure ESOP transactions. Having gone behind the work of other advisors many times, we are often shocked at the mistakes that are made and the opportunities missed.
Some of the major benefits to using an ESOP as a potential exit strategy or liquidity event for shareholders: