Frequently Asked Questions on ESOPs
- What is an ESOP?
- Why Do Employers Implement ESOPs?
- Why Do Workers Get Into ESOPs?
- How Do ESOPs Work?
1. What is an ESOP?
ESOP stands for an Employee Share Ownership Plan. An ESOP is a means employees use to acquire shares in the company where they work. The shares can be held for the employee in a trust or by some other suitable mechanism.
Shares acquired as part of an ESOP can be purchased or granted free-of-charge. Purchase of shares can be financed by a loan, or by deductions from employee salary, bonuses and profit shares.
In simple terms, an ESOP provides a way for employees to become part-owners of the their employer’s business.
In some cases, employees can use an ESOP to acquire the whole of a business.
2. Why do employers implement ESOPs?
From the employer’s perspective, employee participation in the ownership of the business can be used as a way of making incentive payments.
In Australia today most employee share plans are designed to provide such incentives. A performance bonus or a profit share can be delivered via an ESOP in the form of company shares. Australian ESOP legislation is dominated by the idea that Employee Share Ownership Plans are all about incentives. This is only part of the story.
When the perspective switches from incentive to productivity and profitability, employers begin to sense the real power of ESOPs. Companies that seriously want to increase their productivity and profitability will include an ESOP in their planning (see our "Employee Ownership: Why we need it" page).
The productivity and profitability effects of ESOPs are most evident in those businesses where the majority of employees participate in an ESOP and where the employees own a significant part of the company.
The impact of promoting employee ownership upon company productivity and profitability arises, in part, from increased employee identification with the interests and success of the company as their own stake in it increases.
It’s just commons sense. If employees feel that they “belong” to the company in which they work, they will work better and the company’s performance will improve.
The common sense view has been confirmed by research into the effects of ESOPs on business performance. For more information on this aspect, see our page "Employee Share Plans and Company Performance" .
Finally, a business owner might implement an ESOP as part of his retirement or “succession” planning. If the employees are willing, he can use the ESOP to sell them his interest in the company. By this means the owner can extract his “retirement package” from the business assets he has accumulated.
3. Why do workers get into ESOPs?
A major attraction ESOPs have for employees is that they accumulate savings.
Having an element of wages and salary that is saved - once immediate obligations have been met - can be an important draw card for employees, particularly where they can tap into those savings prior to retirement. An employee can do this in Australia because Australian ESOPs stand apart from our compulsory retirement savings programme.
Also, employees are more inclined today to match an employer’s desire for commitment to the business with there own desire to identify with the workplace group or community. The old Bosses-vs-Workers culture is dying. People want to “belong”, and they like their aspiration to be recognised. ESOPs meet that need.
In an economic environment where small business is widespread and franchises are booming in number, many people of modest financial means aspire to be owners. Not all of them, however, are able - or inclined - to start their own business. But increasingly they aspire to own a “piece of the action” in the business that employs them. ESOPs meet this aspiration.
Finally, there are circumstances when employees want to buy the business from their employer. This ambition can arise in varied circumstances. But a key one occurs when the owners (or owners) want to retire (or change their business direction) and need to sell. In these instances an ESOP can be an effective employee buy-out instrument.
Managers do MBOs. Nowadays employees do EMBOs!
4. How do ESOPs work?
Let’s leave aside for a moment how Australian laws governing employee share plans effect the operation of ESOPs under Australian conditions (see our "EOG Policy" page). Let’s just focus here on how ESOPs work conceptually.
First, we’ll assume that the ESOP uses a trust. It need not do so. But a trust-based ESOP illustrates the concept of an Employee Share Ownership Plan in its purest and most powerful form.
Step 1. The employer establishes an ESOP trust the purpose of which is to hold shares in the employer’s company on behalf of the employees.
Step 2. The employer makes an offer to employees to participate in an Employee Share Ownership Plan. The offer sets out the terms of participation in the plan: the conditions an employee must meet in order to participate in the ESOP; the number of shares to be acquired by each employee; the cost, if any, of acquiring the shares; the terms and conditions under which the individual employee can hold the shares; and, finally, how and under what conditions, the shares pass from the ESOP to the employee or, alternatively, how and under what conditions the employee receives the value of the shares held for him in the ESOP trust.
Step 3. If the shares are offered free to employees, the shares are granted to the trustee of the ESOP who allocates them to accounts in the name of the individual employees.
In most cases, however, the ESOP trustee purchases shares in the employer’s company. The purchase is funded by contributions to the ESOP made by the employer. These contributions can be sourced from salary, bonuses, profit shares and other financial awards due to employees, but sacrificed by them in return for the value of the awards being contributed to the ESOP. The ESOP trustee then uses this money to buy employer-company shares and allocates them to the accounts of the individual employees.
Sometimes the ESOP trustee uses finance sourced from a bank loan to the ESOP with which to acquire shares in the employer’s company. In this case, the employer would normally guarantee repayment of the loan, and would make contributions to the ESOP sufficient for the trustee to meet those obligations. ESOP “leveraging” of this kind would be employed where the employees are using the ESOP to buy-out a business, or to acquire a large stake in one. An employee buy-out or EMBO would normally use such leveraged ESOPs.
Step 4. Step 4 is not so much a step as a prevailing set of conditions. The shares allocated to individual employee accounts may be subject to “vesting conditions”. That is to say, a parcel of shares can be “earmarked” for a particular employee, but that employee cannot dispose immediately of the shares as if they were his own. In order to do so, he might have to meet certain preliminary requirements. These could include expectations relating to length of service, to personal and corporate performance, or to the repayment of any debt incurred to purchase the shares. These “vesting conditions” would normally be set out in the offer documents issued by the employer to employees in Step 2. When all the conditions are met, the shares are said to be “fully vested”.
Step 5. When shares are “fully vested”, the employee acquires a right to dispose of the shares, or at least to benefit from the value represented by the shares registered to his ESOP account. There are, as we imply here, two principal ways for an employee to “tap” the assets he has built up in the ESOP.
One way is for the employee to direct the ESOP trustee to transfer some, or all, of his shares out of the ESOP and to register them in his own name. At this point, the new, direct shareholder (who may, or may not, still be an employee of the company) has a personal decision to make about whether to hold or to sell the shares.
The other way is for the ESOP to pay out the departing member (typically one who is separating from the company), while retaining what were his shares in the ESOP for the benefit of new and continuing members. In this case, the departing member would only receive the cash value of the shares held in his ESOP account. This method of dealing with a departing member would most likely operate in an ESOP company that placed a high value on employee ownership and did not want to see the employee’s stake in the business diminished when employees leave the company. For example, a company acquired by its employees through an EMBO would probably use this method of handling a separation