What is Employee Stock Ownership?

As business owners and managers, we’re continuously challenged to find creative ways to ensure employee retention and employee engagement as freelancing and self-employment become more popular options.

Companies are starting to realize that offering workers with actual stock breaks their tunnel vision and helps them think long-term.

Employees then look beyond their own projects and deadlines and instead start making daily decisions that will move their organizations forward and toward financial sustainability.

But what is employee stock ownership exactly and why is it becoming a rising trend today?

How Does Employee Stock Ownership Work?

Business owners can sell some or all of their shares to people who work for them through employee stock ownership.

Companies can establish a trust fund where they pour in new shares of their own stock or cash to buy existing shares. The trust owns the shares on behalf of the employees, who receive the benefits when they leave their job.

In the US, at least 6,500 employee stock ownership plans are currently in existence nationwide as of 2018.

Reasons for Setting Up Employee Stock Ownership Plans

There are a variety of reasons why companies decide to offer employee stock ownership plans besides attracting and retaining good talent.

Additional capital

Employees can buy shares or take lower wages in return for stock to help raise business capital needed for expansion and other business activities, such as hiring new people, purchasing new equipment, or adding new products and services.

Tax benefits

An employee stock ownership plan is tax-free; employees aren’t taxed on employer contributions. Workers are also not taxed if your company’s trust borrows money—through a loan—to buy shares. They are in fact tax-deductible for business owners.

No taxes are imposed on employees amid increased ownership percentage in stocks. Employee stock ownership plan distributions can be subject to IRA rules—but as gains tax instead of income tax.

Small businesses that are fully employee-owned are exempt from corporate income tax.

Shared entrepreneurship

It’s tricky to get a new business up and running, especially for start-ups and owners of small to medium-sized businesses. Owners can use employee stock ownership plans to ease the load.

Succession or business continuity

Business owners can set up an employee stock ownership plan to preserve the company and culture that they worked hard to build.

The plans become practical solutions for private, family enterprises that don’t have next-generation family members or lack outside buyers who can take over their company’s ownership.

Better performance

Findings from the famous 2000 Rutgers Study showed that sales and employment of firms which adopted employment stock ownership plans rose between 2.3% and 2.4%.

The manpower growth in these kinds of firms may be due to higher pay and better job quality as indicated by an NCEO study released in 2018.

In 1997, more than 5,000 employees working at companies with employee stock ownership plans earned higher incomes and enjoyed better benefits than their counterparts in whatever industry they were in.

The respondents were again surveyed in 2013, when they were 28-34 years old, and they said their salaries rose by 30%, while their median household wealth nearly doubled.

Peter Walsh, a partner at Oliver Wyman, highlights several trends that, in the next 10 years, will support the growth of companies with employee stock ownership plans:

  • The retirement of Baby Boomer owners and their commitment to make local communities economically viable
  • The resilience of worker-owned firms over their competitors during economic crises
  • The viability of using the employee stock ownership plan for an employee buyout during financial distress

Basic Types of Employee Stock Ownership Plans

There are three main types:

1. Unleveraged

The most basic type is unleveraged employee stock ownership plans, wherein employers make regular contributions. These contributions become known as “newly issued shares” that are issued to the plan trust.

This type is ideal for companies whose owners want to be bought out over time. Unleveraged plans can also be used as rewards for staff staying with the company over extended periods of time.

2. Leveraged

The second general type is leveraged plans, which take out loans from a bank or lender for the purchase of shares in the company by current owners. The firm later makes regular contributions to repay the loan.

Leveraged plans may be set up to buy shares from retiring owners, buy out entire businesses, or finance new capital.

3. Issuance

The least common form of employee stock ownership plans is issuance. In this type of plan, the employer makes regular contributions using newly issued shares of company stock rather than cash.

Business owners can use this if they want to issue new shares instead of contributing profits to the plan.

When Are Employee Stock Ownership Plans Not Advisable?

Despite its good points, consultancies acknowledge that employee stock ownership plans are not for everyone. The NCEO discourages companies from setting up an employee stock ownership plan if:

  • There isn’t any capable successor in place to handle the business
  • The board or family members are seeking major share of the organization
  • The board as a whole doesn’t agree with the idea of employees becoming co-owners or owners because employee ownership will imply access to more information, decision-making, etc.
  • A synergistic buyer wants to pay a significant premium for the business, and the seller or owner has plans to get out entirely
  • The payroll isn’t big enough
  • There isn’t enough profit for contributions
  • The company is unable to pay for setting up the employee stock ownership plan. NCEO pegs the cost of setting up at $80,000

How to Establish an Employee Stock Ownership Plan

If you have decided to explore the possibility of having an employee stock ownership plan, here’s how to set one up for your company:

  • Find out first if the existing owners and their partners are open to the idea.
  • Conduct a valuation. The valuation — an estimate of how much the company is worth — will be the basis of the feasibility study, which will assess the extra cash flow the firm has to dedicate to the employee stock ownership plan and if the amount is enough for the plan’s intended purpose.
  • Conduct a feasibility study. This can be done in-house or through an outside consultant who will be contracted to do management interviews, market surveys, and financial forecasts.
  • Hire an attorney. If we get positive outcomes from steps 1 to 3, we need the services of an attorney to draft the employee stock ownership plan and submit it to the Internal Revenue Service.
  • Shop around for financiers. These could be banks, ongoing company contributions, and existing benefit plans.
  • Set up an implementation strategy for the employee stock ownership plan. Appoint a trustee to oversee the plan, represent the employees, and receive direction from a plan committee composed of management and non-management representatives.
  • The trustee and committee must then roll out a program to explain the employee stock ownership plan to employees and encourage their involvement as owners.

Many organizations are cultivating employees who perform like owners.

If the company conditions are right, partial or full employee ownership can create a thriving and democratic business where employees benefit from the financial literacy and transparency that come with understanding their new employee stock ownership plan structure.