How an ESOP Works: A Guide to Employee Stock Ownership Plans

Employee Stock Ownership Plans (ESOPs) are often misunderstood due to the unique way they function compared to traditional ownership structures. One of the most common areas of confusion is how a trust gains equity, allocates shares to employees, and how the company repurchases stock from employee owners. In this blog post, we will break down the mechanics of an ESOP to clarify how it works and what makes it a powerful tool for business ownership transitions.

How Does an Employee Stock Ownership Trust Acquire Shares?

When a company implements an ESOP, the stock isn’t directly transferred to employees. Instead, an Employee Stock Ownership Trust (ESOT) is established to hold the company’s shares on behalf of the employees. The ESOT acts as a central entity that manages and distributes ownership to employees over time. Here’s how it typically works:

1. The Trust Buys the Stock: The ESOT acquires equity in one of two main ways:

   • Stock Purchase from Owners: In a leveraged ESOP, the trust purchases shares from current owners, often using financing arranged by the company. This purchase is negotiated with the ESOP trustee, ensuring the stock is sold at fair market value.

   • Issuance of New Shares: The company can issue new shares and transfer them to the trust, either as a lump sum or in multiple transactions over time.

2. Financing the Transaction: Employees do not pay out-of-pocket for shares. Instead, the company typically secures financing for the transaction. The financing may come from:

   • Third-Party Debt: The company may also secure loans from commercial banks or private lenders. The company repays this debt using pre-tax corporate cash flow, and as the debt is repaid, the corresponding stock is released to the trust.

   • Seller Notes: The selling shareholders finance the sale by issuing notes that are repaid over time.

How Are ESOP Shares Allocated to Employees?

Once the trust holds the stock, the next step is to allocate those shares to employees. Here are the key details of how this works:

1. Eligibility: ESOPs are non-discriminatory benefit plans, meaning all full-time employees are typically eligible to participate. Some groups, such as union members, may be excluded depending on how the plan is structured.

2. Annual Allocations: Rather than distributing all shares at once, ESOPs are designed as rolling benefit plans. Each year, eligible employees receive shares proportional to their annual salaries. For example, an employee earning $100,000 would receive twice as many shares as one earning $50,000.

3. Vesting Schedule: Employees do not immediately own their allocated shares. Similar to 401(k) plans, ESOP shares follow a vesting schedule. There are two main types of vesting:

   • Cliff Vesting: Employees fully vest after a set period, which cannot exceed three years of service. If an employee leaves before the vesting period, they forfeit all allocated shares.

   • Graded Vesting: Employees gradually vest over time. A typical schedule might see employees vest 20% of their shares after two years, gaining an additional 20% each year until fully vested after six years.

4. Unvested Shares: If an employee leaves before fully vesting, their unvested shares are usually reallocated to other plan participants.

Redeeming Employee-Owned Shares?

The true financial benefit of an ESOP comes when employees leave the company, at which point they can redeem their shares. Here’s how the process works:

1. Repurchasing Shares: When employees leave the company (either through retirement, resignation, or termination), the vested shares in their ESOP account are repurchased by the company at fair market value, determined by an independent valuation. Employees don’t sell the shares themselves; the trust orchestrates the transaction on their behalf.

2. Payment Schedules:

   • Retirement or Disability: If an employee retires, becomes disabled, or passes away, payments for their vested shares must begin no later than the following plan year.

   • Other Departures: For employees who leave for reasons other than retirement (dismissal, quitting, etc.), payments must begin within six years after their employment ends.

3. Distribution Options: The company may make payments as a lump sum or over time (typically over five years). Employees can, if appropriate, roll their proceeds into another qualified retirement plan. If not rolled over, the proceeds are usually subject to ordinary income taxes.

There are a few notable exceptions to these payment schedules. With that in mind, it’s important to work with an experienced third-party administrator to keep track of all the odds and ends.

What Happens if the Company Is Sold?

If an ESOP-owned company is sold to an outside party (such as a strategic buyer or private equity), the trust plays a central role. ESOP trustees, who act on behalf of the employee-owners, must approve the sale to ensure that employees receive fair market value for their shares.

If the company is acquired by another employee-owned company, it’s possible that the shares could roll over into the acquiring entity’s ESOP. Otherwise, employees receive compensation for their shares based on the sale price.

Why ESOP Education and working with a Certified Employee Ownership Advisor Matter

Many companies dismiss the idea of an ESOP because they don’t fully understand how it works or underestimate the value of employee ownership. When properly executed, an ESOP can offer a valuable liquidity strategy for owners while providing significant tax benefits and cultural advantages for the company.

However, companies that adopt ESOPs without fully educating employees often fail to realize the full potential of employee ownership. This is why working with experienced advisors and understanding the nuances of the ESOP process is critical.