ESOP or Employee Stock Ownership Plan

ESOP is the most common kind of employee ownership plan used in the US.

Are you considering offering ESOPs (Employee stock ownership plan) to your employees, or are you an employee and about to receive ESOP as a bonus from your company? You may have many questions about what an ESOP is and how it works. Regardless of if you are an entrepreneur, employer or employee, you should know all about the benefits of ESOPs along with all the ESOP rules and regulations.

To begin with, an ESOP is the most common kind of employee ownership plan used in the US. In fact, there are about 6,669 ESOP plans all around the US, covering about 14.4 million people nationwide. So, as ESOPs are becoming increasingly more popular among companies, it is high time for you to take advantage of this. Here, you will learn all you need to know about ESOPs.

What is an ESOP or Employee Stock Ownership Plan?

An ESOP, or employee stock ownership plan, offers workers ownership interest through employee stock options in the company. This plan is created to offer the employees the chance to purchase stock in a closely held company to promote company growth.

Since ESOP shares are a part of a bonus package for an employee, companies use ESOPs to keep the plan participants focused on share price appreciation and corporate performance. ESOPs encourage employees to do what is best for both the company, and in turn, the shareholder with the appreciation of their stock. The owners also enjoy tax benefits by offering ESOPs to their employees. And with these share plans, employers can retain the best talent by offering extra incentives for their staff, which would help grow the company.

But just to be on the safe side, these companies usually add a vesting schedule within the ESOP. This helps protect the company in case the employees leave the company before the ESOPs fully vest. When the shares become fully vested and if the employees choose to stay with the company, they can keep the shares and become a shareholder. If they choose to resign or retire from the company, and the shares are fully vested, the company can repurchase the shares. Otherwise, these shares are automatically forfeited and taken back from the shareholder.

Note: Employees that retire or resign usually cannot take the shares from the ESOP with them. They are only allowed to take a cash payment obtained from it. On the other hand, the employees that have been let go usually qualify for the amount that they have vested in the plan.

Why do companies offer ESOPs to their Employees?

The answer to this question is very simple; employers use ESOPs to attract and retain the highest quality employees by offering them employee stock options in the company. And these shares are distributed by the employer in a phased manner. For example, the employer can grant their employees with stock options at the close of the financial year. This would incentivize the employees for staying with the company longer to get the option grants.

Additionally, the companies that offer ESOPs have long-term objectives. They do not just want to retain their employees for the long-term, but also want to make the employees the shareholders of the company, to have a common objective between the two. This would ultimately result in the growth of the company.

In fact, most IT companies have alarming attrition rates (staff turnover rates). And by offering employee stock option plans to the employees, it would help the company bring down the heavy turnover. Moreover, many startups like these are cash-strapped and aren’t able to offer a high starting salary. Due to this, they offer a stake in their organization, making their package highly competitive in the market and attracting talented people.

How do Employees Benefit from an ESOP?

We now know why ESOPs are great for employers, but what benefit does it offer to employees? Before we cover the benefits, let us understand how an employee needs to look at these employee stock options. When an employee is offered a job that includes ESOPs, they should analyze how the long-term value of the employee stock ownership plan compares to the earning opportunities in other companies.

Basically, the employee has to access the number of stocks they can get in their time with the company and how it would benefit them in the long-term. And if it is seen that the ESOP offering would benefit the employee in the long-term, that is when it makes sense to stick with the company. Otherwise, the employee should consider other options if the stock options are not worth it.

Here are some of the basic benefits of an ESOP for employees:

  • ESOPs offer job security, non-monetary benefits, and satisfaction to the employees.
  • Responsibility of the employees towards the company elevates, which also motivates them to participate in the decision making of the company actively.
  • Assurance of a comfortable retirement for employees.
  • Financial benefits in the form of share benefits, higher pay, and wealth generation.

There are a lot of success stories of employees who have become rich after they were offered employee stock options in their company. One such example is Google. Here, both the founders and the stockholder employees became millionaires. The chief executive of Google, Charlie Ayers, obtained employee stock options from the company worth $26 million.

In fact, the large gains made from these employees would never have been able to be achieved in a lifetime through a traditional salary. In Google’s case, about 900 employees became millionaires when the company went public in 2004. So, it may be the best option for any employee to consider ESOPs when entering a company.

Common Questions Asked about ESOP

For those who have some doubts, here are some common questions that will help you understand ESOPs better:

#1 What is an ESOP?

An ESOP (employee stock ownership plan) is an employee benefit plan that offers workers in a company with an ownership interest in the company. The owners in the company set up the ESOP plan to attract and retain the best talent in the industry. Read this article from the beginning to understand ESOPs better.

#2 What happens to ESOP if your company Sold?

There are a lot of cases that can take place when your company is sold. In the first case, let us say that your company is sold to another ESOP company. Here, you would have your ESOP shares rolled over into the shares of the new company employee stock ownership plan. In other cases, the acquiring company would cash out all your shares and roll the proceeds into an account in your name in their 401(k) plan. There are cases where the company might buy your shares and give you the cash.

Regardless of whatever happens, you need to know that most acquisitions take time. Even if a company has been purchased, the funds in the ESOP can be held in an escrow account until all the remaining issues in the sale are complete, such as satisfying certain conditions for the sale or resolving any liabilities the company may have.

#3 How to cash out an ESOP after quitting?

With an employee stock ownership plan, you would get stock of your company for free as per the ESOP plan. And if you decide to leave the company, have become disabled, or retire from your job, you can expect to get the distributions from the beginning of the next year based on the ESOP plan document. If you pass away at any point, your beneficiaries would get the distributions in the next year. And if you are laid off or quit your job, you might not get the distributions for up to six years.

Here are some additional points you should keep in mind:

  • Your Annual Account Statement: According to the law, your company has to send you an annual statement that reports the amount of stock and cash in your ESOP account. This will also have all the details of the vesting schedule and how many shares have vested. You can get a copy of this from your HR department.
  • Deferred ESOP Distributions: As mentioned above, if you are laid off or quit, the ESOP distributions are deferred for six years under IRS regulations. After six years, you will get the value of your ESOP in either partial payments over five years or in one lump-sum. The lump-sum distribution can consist of stock, shares or a combination of both, and the annual portion would be in stocks.
  • Your ESOP Distribution Policy: Ensure that the ESOP has a distribution policy that outlines exactly how the shares, stock or cash will be distributed.
  • Retirement Account Transfers: If you want to stay safe from paying a 10% penalty on your early ESOP withdrawal, it is better to roll over the money in your ESOP into a retirement account (such as an IRA). And once you become 59 ½ years old, you can withdraw it and avoid penalties. But remember that you will still have to pay the income tax for the profits gained.

In short, an ESOP is a great plan not just for the employees but also for the company. And being an employer, as you give out shares from your company, remember to keep track of it. You can use Eqvista, which is a cap table software that would help you to easily track and manage the shares in your company.

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