An ESOP is an employee stock ownership plan. It is a benefit plan which allows the company to set up a trust fund. Then tax-deductible contributions of new shares of its own stock can be distributed to buy existing shares, converted to cash, or create a market for closely-held shares of a departing shareholder.
ESOPs are also used to reward employees by giving them access to a piece of company ownership.
An ESPP is an employee stock purchase program. These exist in publicly-traded companies, allowing an employee to contribute a percentage of their pay each month toward the purchase of company stock. When a pre-determined interval occurs, which is usually every 6 months, then the balance that has been saved by the employee is used to purchase stock at a discounted rate.
List of the Pros of an ESOP
1. It provides internal control over each transaction.
ESOPs are a good tool to use when there is doubt about the continuation of a business over the long-term. Many owners have worked hard to establish their business and brand, but if stock is issued in a general way, they could lose some of that control. When compared to an external sale, a company owner can use an ESOP to raise funds for themselves without loss of a control and do so in a faster time period.
2. It can become a gradual transition.
An ESOP doesn’t force owners into a fast decision to liquidate their assets in a company. They can choose to sell partial ownership through an ESOP, even maintaining majority control. If a minority stake is issued through an ESOP, the ownership with a majority stake is still permitted to sell the company to third parties in the future.
3. It creates liquid capital.
Many owners have assets tied up in their businesses that are difficult to access from a cash standpoint. With the creation of an ESOP, business owners can begin the process of converting their closely-held shares into capital that is more diversified and liquid than in its present form.
4. It provides a morale boost to the organization.
Employees who are able to participate in an ESOP will often find value in the vestment opportunities that are provided to them. When the company grows, then the wealth of the employee grows. It gives workers an incentive to be productive because it helps their bank account at the same time. This can lead to higher levels of overall success.
5. It offers tax advantages.
The principal amount of an ESOP loan may be tax deductible for some individuals. Selling shareholders may elect to take advantage of Section 1042 deferrals to indefinitely defer capital gains associated with their sales. Within an S Corporation, the share of recognized earnings from an ESOP is usually exempt from income taxes.
List of the Cons of an ESOP
1. It is difficult to maximize the proceeds of an ESOP.
Current shareholders within an organization are not likely to maximize the proceeds which occur from an ESOP. That is because the average ESOP buyer is financially motivated, not strategically motivated. An ESOP can pay up to the fair-market value of the stock, but nothing more. Strategic buyers are sometimes able to pay more, looking to recoup the difference with future growth opportunities.
2. A 100% ESOP may demotivate potential investors.
When a company decides to sell 100% of their outstanding shares through an ESOP, then outside lenders become less motivated to provide financing opportunities. That means seller financing may be required to cover the balance of a potential activity from the company in the future.
3. There are ongoing costs that must be considered.
An ESOP is like any other stock management plan. There are going to be administrative costs that must be paid. An annual valuation must take place, which provides an added cost. There are also administration fees, trustee fees, and legal fees which may apply. That is why an initial investment into proper guidance is necessary when looking at the pros and cons of an ESOP. Unexpected expenses can spiral out-of-control very quickly.
4. It may cause regulatory headaches.
An ESOP is required to follow all current security, tax, and market laws and regulations. These happen in the foundation of plan administration, which is usually overseen by the company’s human resources department. If the plan is not compliant, then the money employees have put into it may not have as much value. That would contribute to lower overall employee morale to the point that turnover rates may increase.
List of the Pros of an ESPP
1. There can be huge gains for employees with this program.
Let’s say that the stock is $25 today, when the price is set for the ESPP purchasing program. Over the next 6 months, you are saving money to purchase that stock when the period to do so opens again. In that time, let’s say the stock goes up to $50. If you sell that stock immediately, you’re going to end up doubling the amount earned from the saving period. Many workers see the presence of an ESPP as a “guaranteed bonus” that happens for them at every vesting and purchase period.
2. It creates an alignment of interests.
Many employees are not focused on the big vision or mission of the company. They’re concerned about making sure their job is done correctly to keep earning a paycheck. By offering an ESPP, companies are able to shift this vision toward the long-term future. It creates an opportunity where there is an alignment in interests.
3. It offers a vesting period.
Even with ESPP benefits in place, there are often vesting periods required to obtain the full value of the stock purchase. When a stock offers a good value bump to a worker’s income, you’re more likely to retain your top workers to continue pushing forward on growth. At the same time, you’re able to instill a certain level of pride within the workforce that encourages higher levels of productivity.
4. It may reduce turnover rates.
When a good ESPP is in place, the rates of turnover and churn in the standard employee population will often go down. That happens because workers begin to see their job as more of a long-term investment instead of a short-term gain. There are also higher levels of loyalty and commitment from within each team because people can pursue what they are passionate about, which further reduces turnover.
List of the Cons of an ESPP
1. There isn’t a guarantee that employees come out ahead.
Most ESPPs will allow for a discount on the purchase price of the stock or a stock option price that provides a discount to the employee. If the ESPP is setup more like a traditional stock option, however, then there is a chance that employees may not be able to benefit from this program. If the stock is priced at $25, but the option to buy through the ESPP is $30, then it would be $5 cheaper to go through the general market.
2. There may be a required holding period.
Before getting involved with a company’s ESPP, you’ll want to carefully read through their summary plan description. It is sometimes called an SPD. You’ll want to see if there is a required holding period in place before you’re able to sell the stock that you purchase. If you’re not able to cash out the stock right away, then you may find that the total gains you’re able to achieve with an ESPP may be somewhat limited.
3. There are tax implications to consider.
In the United States, if you sell your ESPP stock purchase immediately for a profit, then you’ll pay the ordinary income tax on the discount you’re provided, which is usually 15%. On a $1,000 purchase, the income tax would be applied to $150. Then you’d be responsible for short-term capital gain taxes on the profits you’re able to achieve from the sale of the stock.
4. There are regulatory issues to consider.
As with an ESOP, ESPPs must be in regulatory compliance to offer their potential benefits. That requires a company to have a compliance officer overseeing the program, ensuring that all tax and security laws are followed. Even if this is all handled by the book, an unexpected drop in share pricing can still cause morale issues that can make the workplace become a negative space.
ESOPs and ESPPs are two excellent ways to offer employees a unique benefit. When workers have a chance to take ownership of their company and their work, it leads to higher levels of happiness and financial security. That leads to more productivity. Although there are potential disadvantages that must be considered, either option is a good way to incentivize workers.
Blog Post Author Credentials
Louise Gaille is the author of this post. She received her B.A. in Economics from the University of Washington. In addition to being a seasoned writer, Louise has almost a decade of experience in Banking and Finance. If you have any suggestions on how to make this post better, then go here to contact our team.