Also known as non-leveraged ESOPs, employers fund the unleveraged ESOPs directly without borrowing money. To do so, they regularly contribute additional funds directly to the unleveraged ESOP. Upon issuance of the new shares of stock by the sponsoring company, a deduction for the market value would be taken for the stock that they contributed to the ESOP.

These are ESOP plans that companies grow partly or wholly through the use of borrowed funds. The money from a lender is being utilized to buy back shares from stock-owning employees once they retire or leave, and then the loan would be paid back over time in lieu of making direct contributions.

This type of ESOP involves adding new shares of stock to the trust. The sponsoring business dilutes the value of the current shares instead of contributing cash to boost the number of stocks that they can offer to new and current employees.

The Employee Stock Ownership plan takes into place once the shares of the company are sold to an ESOP trustee with proper negotiation.  During the negotiation, the market value of the company as well as other aspects including financing, board composition, levels of ESOP benefits, management incentive plans, and indemnity agreements are taken into consideration.

Usually, the seller hires an advisor to handle the sale process from beginning until the end.  This way, the success of the negotiation is ensured.  But before going into the negotiation, your advisor will look into whether an ESOP is feasible by doing an initial study.  After a thorough analysis and it has been evaluated that an ESOP is deemed necessary, your advisor can help in establishing a raise in the capital, plan design, entity restructuring, and the dialogue with the trustee as well as the capital sources.

There are no upfront costs when companies provide employees ownership through ESOP. The company holds the provided shares through a trust for safety and growth and are received by the employees upon exit or retirement. Distributions are normally tied from the plan to vesting giving employees rights to employer-provided assets through time (in which they typically earn an increasing percentage of shares for every year of their service).

The company repurchases the vested shares back from fully vested employees who retire or resign from the company. The employees receive the money in a lump sum or equal periodic payments (depending on the plan). After repurchasing those shares, the company then redistributes or voids the shares.

Those leaving the company voluntarily are not allowed to take the shares or stocks with them (only cash payment). Employees who were fired usually qualify only for the amount that they have vested in the ESOP.

Stock ownership plans like ESOP act as additional benefits for employees with the goal of preventing opposition from employees and to align the corporate culture that the company management wants to uphold. There are other versions of employee ownership. They are:

Direct-Purchase Program: This allows employees to purchase shares of their respective companies with their personal after-tax money.

Restricted Stock: This gives employees the right to receive shares as a gift or a purchased item after complying with particular restrictions like working for a certain period of time or meeting specific performance targets.

Stock Option: This provides employees the chance to buy shares at a fixed price for a set period.

Phantom Stock: This provides cash bonuses for employees with good performance.

The mentioned bonuses are equivalent to a specific number of shares with stock appreciation rights confer employees the right to increase the value of an assigned number of shares. These shares are usually paid by companies in the form of cash.

Think about an employee who has worked at a large company for ten years in which he is given the right to receive 10 shares after the first year and a total of 100 shares after 10 years. Upon the employee’s retirement, he will receive the share value in cash. These stock ownership plans may include stock options, restricted shares, and stock appreciation rights, among others. 

Employee-owned corporations are those companies with a majority employee-ownership (similar to worker cooperatives). In an ESOP, the company’s capital is not distributed evenly with the senior employees having larger allocated shares as compared to the newly-hired ones (and so the former have higher voting power during shareholder meetings).

An employee stock ownership plan can be leveraged or non-leveraged.  Let’s tackle each one.  When it comes to the non-leveraged ESOP, shares or cash are contributed to the ESOP.  After the contribution, the shares are distributed among the employee accounts.  The distribution is based on the employee’s tenure, salary, or both.  In return, there will be a tax deduction on the part of the company for the market value of the shares or cash that is contributed to the plan.

In the United States, ESOP is the only qualified retirement plan that is allowed to borrow money, which takes us to the leveraged ESOP.  Leveraged ESOP follows a different way.  In this, shares of stock are bought by the ESOP with a note coming from the selling shareholders or the company.  When the note is repaid, the shares are distributed to the accounts of the employees.  Repayment of the note can be tax-deductible while the shares are subjected to vesting.  So, once the employee decided to leave the company, he or she will receive a payment for the shares in a lump sum or distributed through the years.

Looking at both situations, we can tell that the employee is subject to the benefits of the shares while the ESOP trust manages the shares and is deemed the only shareholder.  The trustee also has the depository duty to ensure that the retirement benefits of the employees are protected.  Even they do manage the shares, the trustee is not expected to intervene with anything regarding the daily operation of the company or be part of the board of directors.  Their primary role is to make sure that any company action has done is for the benefit of the employees.

The quick answer is it depends on the business owner.  With ESOP, the owner or shareholder can decide how much of the business they want to sell and the timeframe.  There are times that the business owner sells a small part then does a second-time transaction later on.  When it comes to the timeframe, it is up to the shareholder.  Many business owners are enticed with the benefits of a 100%-owned ESOP and usually go for it.  Aside from that, to be entitled to the 1042 tax-free rollover, there should be enough shares to quality for 30% ESOP ownership requirement.

Now, the question of value comes to light.  Every year, the business is valued by a qualified valuation firm that the trustee has chosen.  The reason for the valuation is to evaluate the business’ yearly share price and to determine the value of each employee’s ESOP account.  At that point, the business is subjected to a value that a buyer and seller would agree on.  In instances that a management incentive plan and warrants are included, the value is often related to the yearly valuation of the underlying shares.

There are certain leverages when selling to an ESOP over another buyer and vice versa.  First, ESOP offers a fair market value for the company stocks just like any typical buyer.  But, there is a chance that the seller may receive a lower compensation if the ownership is sold to the ESOP than to a buyer.  Although that is the case, one can have better tax savings when it is sold to ESOP.  The sale can increase the after-tax proceeds to the selling shareholder.  Another would be up to a 25% tax deduction on payroll with the ESOP contributions made per year.  Furthermore, selling it to the ESOP can remove any in-progress tax or corporation distribution obligations which then give beneficial tax savings.  On top of that, as the profit is passed onto the shareholders, the percentage of the company owned by the ESOP is tax-exempt.

Once the shares of the company are sold to an ESOP, they defer capital gains which also results in the elimination of the capital gain taxes.  In section 1042 of IRC, it states that once the sale of an ESOP is done, (1) the ESOP is entitled to 30% of the stocks in the business, (2) the business is a C corporation, and (3) you already owned the stock for three years, which will likely be the means to defer capital gains tax indefinitely.

If the proceeds from the ESOP sale are reinvested into a qualified replacement property and it’s held until the death of the investor, the beneficiary will receive a step-up in basis and is not subjected to capital gain taxes on the principal and market appreciation.  The qualified replacement property includes bonds, domestic stocks, and corporate floating rate notes.

Many are intrigued by how the business benefits from selling the ownership to the ESOP.  Well, it will start with commercial banks stepping in.  Banks are more than willing to lend funds to companies they know creditworthy because they are also knowledgeable about the sale process of ESOP.  As for the balance on sale, it could come from other lenders.  One alternative lender like mezzanine providers may seek a higher return rather than a lender who has been in the business for a long time.  This can also be expensive.  In the event that the business owner does not want to go with a mezzanine financing, they can opt-in capital with seller notes which may include warrants, cash pay interest, or both. 

Going with the second option, the seller has the chance to receive a high cash pay interest or reduce the interest rate and make it up with warrants.  If you aren’t familiar with warrants, it is a financial instrument that allows the holder to own future equity of the company.  The interested payments to the notes of the seller are treated will be subject to ordinary income tax while the warrant is subject to capital gains tax (typically lower than the ordinary income tax).  We know how high-interest payments are a burden and hurt the business’ cash flow.  Also, the warrant gives the seller a lower annual cash return on the seller’s notes.  This benefits both the seller and the company. 

While ESOP and EOT share the same ideology when it comes to it being a true employee ownership model, they have their rightful differences.  First, ESOPs are usually common in the United States while EOTs are typically in the United Kingdom.  But the significant difference they have is that in ESOPs, the employees are entitled to receive payment for the value of shares in their retirement accounts upon retiring or leaving the company.  On the other hand, when it comes to EOT, employees are not entitled to the shares.  A trustee manages the shares on behalf of all employees.

No Diversification

When you are an ESOP member, your retirement savings is merely focused on one company. This goes against the rule of investment theory which advises diverse investments (industries, locations, companies). Employees’ savings are also locked into the same company where they are dependent on salaries, insurance, and other benefits. The drawback on this is when the company collapses, the employees are also at the risk of losing not just their income but also their savings.

Limited Opportunities for Newer Employees

With an ESOP, newer employees have limited benefits since those who have been enrolled earlier are the ones who are benefitting from the continuous contribution to the plan (with the latter given a higher voting power). Even in stable companies, newer employees are not given much opportunity to accumulate as much savings as those compared to the tenured employees. This, they are given limited opportunity also to partake in the company’s vital decisions during the general meetings and forums.

Dilutive

In an EOP, share ownership is dilutive which means that as more employees join the company and the shares are allocated among a bigger number of members, the percentage of ownership that each share holds reduces. This is also applicable even to the percentages of the shares that the older members hold in the plan. This then results to reduced voting powers of those who used to have high voter powers.