How an ESOP Works

The mechanics of employee stock ownership plans are a frequent source of confusion. Understanding how an employee trust gains equity, allocates shares, and how sponsors repurchase company stock are among the most important concepts in an ESOP education.

A thorough understanding of these fundamentals can empower leadership teams to make informed decisions regarding plan design and administration. Employee owners who appreciate how an ESOP works are more likely to see the value of their equity participation.

In this article, you'll learn about:

• How an Employee Trust Acquires Shares
• ESOP Share Allocation and Vesting
• How Employee Owners Redeem Shares
• What Happens when ESOP-Owned Companies are Sold

How does an Employee Trust Acquire Shares?

A sponsor company's stock isn't directly transferred to employees. Instead, an employee trust (or ESOT) acquires equity, holds the shares on behalf of plan participants, and manages all allocations.

In general, the trust represents the interests of employee owners vis-à-vis the company sponsoring the plan. A trustee – often selected by an ESOP committee designated by the company’s board of directors – acts as the shareholder of record and has a fiduciary obligation to all plan participants.

An ESOT commonly acquires company stock in one of two ways:

1. Company Issues Stock – Shares are transferred to the trust either in a single tranche or in multiple, periodic transactions. This is commonly referred to as a contributory ESOP.
2. Owners Sell Stock – The employee trust purchases equity from company shareholders. Employees do not pay out of pocket for shares. Instead, the plan sponsor coordinates, extends, and repays transaction financing on the trust's behalf. Stock is released to the trust as the transaction debt is paid down. This is known as a leveraged ESOP.

In either transaction, ESOP stock is priced at fair market value following negotiations between a plan's sponsor and its trustee.

How are ESOP Shares Allocated to Employees?

An ESOP is a non-discriminatory employee benefit plan. As a result, all full-time employees are generally eligible to participate. Certain distinct classes of workers may be excluded, though, such as union members. The sponsor formalizes these details before the plan is formed.

Share allocations typically take place annually.

Even when equity is issued to an employee trust (rather than sold to it), that stock is usually parceled out to participants over multiple years. An employee stock ownership plan is meant to be a rolling employee benefit program, rather than a one-off distribution of stock.

Each year, eligible employees receive share allocations proportional to their annual salaries. For example, an employee earning $100,000 a year would receive twice as many ESOP shares as an employee earning $50,000. Plan participants may also receive cash distributions in addition to their annual stock allocations.

As mentioned earlier, all stock is held by the trust, even post-allocation. Share distributions are not made directly to ESOP participants.

ESOP shares follow a vesting schedule.

Similar to 401(k) plans, there’s generally a three-to-six-year vesting period for allocated stock. The details are determined before the plan is formed and outlined in the ESOP plan document.

Shares vest in one of two ways:

1. Cliff Vesting – Employees fully vest after working at a company for a set period (no more than 3 years). It’s an all-or-nothing proposition. Employees who depart before attaining this service goal forfeit any shares previously allocated to their accounts.
   
   
2. Graded Vesting – Employees vest gradually, over time, until they are fully vested. A typical structure has employees earning 20% of their shares after two years of service, with an additional 20% each year until they are fully vested (after six years).

Forfeited, unvested shares are usually reallocated to plan participants.

How do Employee Owners Redeem Shares?

Employee owners realize the financial benefits of their ESOP accounts when they depart or retire from their plan's sponsor. At that time, all of their vested stock is sold back to the company.

Shares are priced at a current fair market value, and the transaction is orchestrated by the trust on the employee’s behalf. Once ESOP shares have been repurchased, the sponsor may grant the shares back to the trust for future allocation or retire the shares to treasury.

ESOP distribution schedules vary.

If a participant retires (at or after the plan’s set retirement age), becomes disabled, or passes away, the sponsor must begin payment of the vested benefit no later than the next plan year.

If a participant leaves for another reason (quitting, dismissal, etc.), distributions must begin no later than six years after the plan year in which their employment was terminated.

Full payment is made either periodically (equal payments over a maximum of 5 years) or as a single lump sum. Plan participants can roll their proceeds into another qualified retirement plan. Otherwise, they will generally be 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 an Employee-Owned Company is Sold?

Trustees sign off on any transaction involving company shares, including share buybacks and sales to strategic buyers or private equity firms. In general, they’re not looking to block deals. But ESOP trustees do have a fiduciary responsibility to secure fair market value for all plan participants.

Upon sale to a third party, plan participants receive payment for their vested shares, based on the sale price. Additional considerations apply to unallocated shares when the original ESOP loan remains outstanding.

If an acquirer is also employee-owned, shares may roll over to the merged entity’s employee stock ownership plan.

ESOP Education and Professional Help are Critical

When companies fail to comprehend the mechanics of employee ownership, they often dismiss the concept out of hand. In doing so, they overlook a valuable liquidity strategy and forgo unique corporate and personal tax benefits.

Those that adopt employee stock ownership plans but fail to properly educate participants rarely reap the wide-ranging cultural advantages of employee ownership.

So, if you’re considering a plan, take time to learn the nuances. Surround yourself with the right resources and advisors. ESOPs are complex, but under the right circumstances, they are worth it.