The mechanics of leveraged ESOPs: How they work and who benefits?

Leveraged Employee Stock Ownership Plans, or ESOPs, are an increasingly popular approach to share company ownership with employees. In general terms, ESOP or Employee Stock Ownership Plans, allows employees to purchase the company’s stock they work for at a particular price after a specified date. Well, in this regard, leveraged ESOP plans also work in the same way, however, the idea is that the stock is purchased with bank loans or “debt”. As such, the purpose, structure, and operation of leveraged ESOPs are fundamentally similar to conventional ESOPs. In this article, we will discuss the mechanics of leveraged ESOP, how does a leveraged ESOP work? and who benefits from leveraged ESOPs?

ESOP and leveraged ESOP

To begin with, let us look at the basic meaning and concept of ESOP and leveraged ESOPs. An ESOP is a form of stock-based compensation or equity compensation that enables employees to purchase company stock at a specific price after a specified date. The purpose of an ESOP is to enable the employee to obtain ownership in the company they work for and perhaps, to align the employee’s interests with those of shareholders. Overall, ESOP helps to increase employee morale and can be a valuable component of a company’s employee benefits strategy.

While leveraged ESOPs apply the basic concept of ESOP, the main difference is that leveraged ESOP uses borrowed funds to finance an ESOP as a means of providing employees with equity grants. Thus, leveraged ESOP is a form of employee ownership and employee sharing in which an employee loan is used to finance stock purchases.

What is ESOP?

ESOP is a type of employee ownership through which employees of the company receive shares in the company. ESOPs are implemented in a structured way, which essentially works by providing shares to employees at a pre-determined price after a certain date. In other words, the employees of the company can participate in the ESOP to receive shares in the company they work for.

In recent years, the adoption of ESOP has been increasing dramatically and has become a common feature of new-edge companies. The main reason why ESOP is gaining popularity is that it helps to retain and motivate employees, as well as to increase employee morale. As a result, ESOPs have made considerable progress in terms of their use and popularity.

How does ESOP work?

Basically, the process of employee share ownership plan (ESOP) is quite simple. Selected employees of the company can participate wherein they are provided with a certain proportion of the company’s shares at some point in the future at a predetermined price with specific terms and conditions. Generally, ESOP works by providing shares to employees in the form of equity grants and/or stock options.

The price at which the shares are granted under an ESOP is known as the strike or exercise price and the time period after which the employee can actually purchase the shares is referred to as the vesting period. While the process of purchasing the shares in an ESOP is known as exercise. Therefore, in the end, employees of the company gain ownership in the company they work for through an ESOP after completing the vesting conditions and paying the strike price.

Types of ESOP

You might be asking, what are the different types of ESOPs out there? Well, below we have briefly described the six most common types of ESOP:

• Employee Stock Purchase Plan (ESPP) – An Employee Stock Purchase Plan (ESPP) is a particular type of employee share ownership plan designed mainly for smaller companies. The main purpose of an ESPP is to make shares available to employees at a more affordable price. In this regard, the benefits of an ESPP are to encourage employees to gain ownership at a discounted price, while at the same time, earning a share of the company’s profit through dividends.
• Employee Stock Option Scheme (ESOS) – An Employee Stock Option Scheme (ESOS) is a form of employee share ownership plan that provides employees with the option to buy company stock at a specified price after a certain period of time. In this case, the purpose of an ESOP is to provide employees with the intrinsic motivation of ownership and to engage them in the success of a company.
• Restricted Stock Units (RSUs) – Basically, Restricted Stock Units (RSUs) are a form of equity compensation plan that corresponds to the vesting schedule. In other words, RSU is a method of issuing stock to employees where the actual shares are issued after a predetermined period i.e. after completing a certain milestone or condition.
• Stock Appreciation Rights (SARs) – It is a type of ESOP wherein an employer can offer stock benefits to workers through SARs without reducing their equity. In simpler words, Employees who have Stock Appreciation Rights (SARs), a sort of ESOP, might get paid based on how much the company’s stock appreciates over time. Employers can offer stock benefits to employees through SARs without reducing their equity percentage.
• Restricted Stock Award (RSA) – Restricted Stock Awards (RSA) is a sort of equity compensation in which an employee is granted a particular number of shares subject to certain conditions. RSA share limits are often dependent on the vesting term and other performance criteria. Thus, the purpose of an RSA is to motivate employees and reward them for their performance.
• Phantom Equity Plan (PEP) – A Phantom Equity Plan is similar to a Stock Appreciation Rights Plan. A Phantom Equity Plan (PEP) is a sort of ESOP in which employees are paid according to the value of the company’s stock without owning any shares. Instead of receiving real stock certificates, employees are paid money depending on the appreciation of the stocks.

Benefits of ESOP

Now that you understand the basic concept and procedure of ESOP, let us discuss the benefits of an ESOP. Here are some of the main benefits of an ESOP:

• ESOP is a means of rewarding employees for their services and achievement. The award of shares in the company for long-term employee commitment will ensure that employees remain motivated.
• ESOP helps to boost employee morale and improve company productivity. With ownership comes responsibility, and when employees become shareholders, they will be more committed and responsible in their work toward the company’s success.
• Employees can benefit financially by selling their ESOP shares at some point in time using tender offers, private placements, or after the company goes public. As a result, employees can earn substantial profits.

What is leveraged ESOP?

Probably by now, you have a good understanding of ESOP and its benefits, so you might be wondering what is leveraged ESOPs? Essentially, leveraged ESOP is a type of ESOP in which the company borrows money in order to finance the purchase of the company’s shares by employees. In this regard, the use of borrowed funds is a mechanism that enables companies to reward their employees with equity grants and at the same time reduce cash up-front. Basically, companies take loans against their assets and subsequently pay them back annually through ESOP payments. Thus, ESOP can be set up in the form of a leveraged ESOP that typically uses loans as a way to finance the ESOP.

How does leveraged ESOP work?

In most cases, leveraged ESOPs will involve loans to the company from external sources, the principal of which is repaid back through interest over a certain period of time. Generally, using their own credit to obtain a loan, the plan sponsor in leveraged ESOP transactions uses it to finance the plan through an ESOP trust. The trust then makes use of those funds to buy stock or company shares and gradually repay the loan. Further, the lender distributes shares which is equal to the value of the loan amount when it is repaid. These shares are divided across each employee’s accounts. Once vested, workers are qualified to receive dividends upon retirement or termination of employment.

Difference between leveraged ESOP and non-leveraged ESOP

With this knowledge about leveraged ESOP in hand, let us now compare it with non-leveraged ESOPs. Before we do that, let us first understand the definition of a non-leveraged ESOP. Basically, in a non-leveraged ESOP, whether purchasing shares from employees at distribution or from the seller during the first ESOP transaction, a non-leveraged ESOP does not borrow money to do so.

This is where the main difference between leveraged ESOP and non-leveraged ESOP comes into play. However, the timing limitations for dividends are a significant difference between leveraged and non-leveraged ESOPs. Leveraged ESOPs have the option to postpone the issuance of stock value until the following plan year once the ESOP has already been fully paid.

Pros and cons of leveraged ESOP

Let us now look at some of the advantages and disadvantages of leveraged ESOP in order to have a better understanding of leveraged ESOP. The following are the pros and cons of leveraged ESOPs:

Pros of leveraged ESOP

• Leveraged ESOPs have the ability to reduce cash-out requirements for plan participants. In other words, a company can implement ESOP without having to invest the entire required capital upfront.
• Plan sponsors are eligible for a tax deduction equivalent to the fair market value (FMV) of the shares given to the ESOP. Thus, leverage ESOP can provide significant tax benefits to the plan sponsor.

Cons of leveraged ESOP

• In order to use leverage ESOP, the company must have something valuable to secure the loan. Further, the company must be able to repay the loan principal and interest. Hence, using leverage ESOP will depend upon the company’s financial standing.
• The business must qualify for a loan from the lender as well as comply with the associated loan agreements. As a result, the companies have to go through a loan application process to be able to qualify for a loan and must adhere to strict lending requirements as well.

How do leveraged ESOP transactions work?

Under leveraged ESOPs, a company buys stock from the business or its current owners using the money from a bank loan. An independent appraiser determines the sale price. In general, the company, the selling shareholders, and/or the surviving owners must provide payment guarantees to the lending bank, which holds the acquired shares as security. On behalf of the employee participants, an ESOP trust is established to serve as the authorized shareholder and purchaser of the shares.

The trust purchases the stock or shares from the plan’s sponsor and retains them until annual payments are due. The ESOP receives a yearly tax-deductible contribution from the plan sponsor. These funds are used by the ESOP trust to pay down the initial loan debt. The lender distributes shares that are equivalent to the value of the loan amount when it is repaid.

What are leveraged ESOP tax considerations?

So you have an idea about what leveraged ESOP is and how it works. But what are the leveraged ESOP tax considerations? As a matter of fact, leveraged ESOPs offer tax advantages over non-leveraged ESOPs. Below are some of the leveraged ESOP tax considerations:

• Tax deductions apply to any dividends that the employer distributes to plan participants or uses to pay back the loan.
• The contributions of the employer are created tax-deductible since the employer is considered the plan sponsor.
• Employees are not subject to tax on the shares till the time of distribution of shares takes place.
• The seller, who is also the owner of the business, is permitted to sell shares while deferring paying capital gains taxes on the sale proceeds.

How to choose between leveraged ESOP and non-leveraged ESOP

It depends upon the company’s financial standing, stage of organization, valuation, and other factors. Having said that, there are pros, cons and tax considerations for both leveraged and non-leveraged ESOPs. At any point, a company under leveraged ESOP can convert it to a non-leveraged ESOP. Likewise, it is essential to have a complete understanding of both leveraged ESOP and non-leveraged ESOP before implementing one over the other. As mentioned earlier, each situation is unique and having a sound understanding of the factors that differentiate between leveraged ESOP and non-leveraged ESOP will help you make an informed decision.

Manage your ESOP with Eqvista!

In recent years, ESOP has gained popularity in the business world. It is a way for a company to entice and compensate its employees to ensure long-term growth. Whether it is leveraged ESOP vs non-leveraged ESOP, the benefits that both of these offer to the company are the same. However, equity management with an ESOP can be challenging for startups or even for mature companies. To help you tackle this challenge, Eqvista offers an automated approach to help you execute the equity of your company. With our cap table management software, you can manage multiple shareholders and keep everything in sync. For further details, contact Eqvista!