What is an employee stock ownership plan (ESOP)?

In today's competitive global marketplace, talented individuals are in demand. And attracting and retaining these top-tier employees is a key challenge for any company — especially if you’re hiring internationally.

As a result, you need to offer a compensation and benefits package that makes your company stand out. One such way to do this is to offer employee ownership, usually through an employee stock ownership plan (ESOP).

But what exactly is an ESOP? Why is it such an effective benefit? And how do you set one up when your employees are in different countries, with different laws?

In this guide, we’ll answer these questions and debunk some of the misconceptions about ESOPs. We’ll also cover the various legal considerations you should take into account.

Let's jump right in.

What is an ESOP?

An ESOP is an employee benefit plan that allows your workers to become shareholders in your company and, therefore, part owners of the business.

An ESOP can offer a sense of shared entrepreneurship for your employees, bond workers separated by time zones, and help preserve the culture and vision of your company.

They are a popular benefit with employees, too. In the US, for instance, ESOPs are the most common form of employee ownership, covering around 14 million people, with Europe and Asia not far behind.

How does an ESOP work?

ESOPs are set up as trust funds, and your company contributes new shares into that fund (or money that can be used to purchase existing shares of company stock). 

In most cases, this process is funded by a bank loan; the interest generated by the ESOP then repays the loan. However, if your company has the capital, you can set up an ESOP without a loan. 

Employees don’t pay anything for their shares. Instead, they are awarded as a benefit, with the possibility of accumulating more shares in the future.

When an employee does leave, they are usually entitled to keep the vested portion of their shares. However, this generally depends on how long they have been at your company, as well as how your ESOP is set up.

Note that, in most countries, ESOPs are required by law to have a trustee who manages the plan’s fiduciary responsibilities. The trustee does not have to be independent, although this is generally considered best practice.

What are the different types of ESOPs?

In general, there are three kinds of ESOP: 

1. A non-leveraged ESOP is funded directly by cash or stock contributions from your sponsor or founding shareholder. It doesn’t require a bank or other lenders.

2. An issuance ESOP relies on financing. A loan is used to purchase newly issued shares from your sponsor, and these shares are allocated to the participants’ accounts as the loan is repaid.

3. A leveraged ESOP buyout also requires financing. The loan is used to purchase existing shares from a selling shareholder. This form of ESOP is often used during transitions, such as a company merger or acquisition.

What are the pros and cons of an ESOP?

An ESOP has multiple advantages — but that doesn’t mean employee ownership is the right course for every company. If you’re going to offer this benefit, you need to be committed to employee ownership, and your company culture has to reflect this.

Here are some of the most notable pros and cons of an ESOP.

Advantages of ESOPs

• ESOPs provide a succession plan for employers. Only 35% of businesses have a formal succession planning process in place, according to the Association for Talent Development. An ESOP offers a viable exit strategy, and ensures the business is left in the hands of its most invested guardians: your employees. 

• ESOPs foster a culture of engagement among workers. In an ESOP, everyone has a collective interest in your company’s success. As part owners of the company, your employees may feel more willing and enabled to make suggestions on how to improve certain processes, rather than simply accepting direction. This is beneficial for morale, motivation, and productivity, as employees are no longer just “doing their jobs.”

• ESOPs make ownership transition simpler. Less than 25% of businesses for sale find a buyer — and those that do tend to sell below asking price, according to the International Business Brokers Association. With an ESOP, you can sell ownership of the ESOP trust, and receive a fair market value for the company. You can also opt to retain shares and remain a partner.

• There are significant tax benefits. In most jurisdictions, ESOPs are tax-exempted trusts, meaning that the profits earned by your company go to your employees rather than the tax office. In the US, for instance, S corporations that are 100% employee-owned do not need to pay taxes.

• ESOPs can encourage greater employee retention. With a vested interest in how your organization is run, workers have a strong incentive to stay. And if they accumulate more shares based on the length of time they’ve been with you, it’s in their financial interest to remain with your company.

ESOPs are a key part of a modern benefits stack, which is crucial for attracting and retaining top talent to your organization. From your employees’ point of view, an ESOP can provide:

1. Increased wealth. A well-run ESOP offers significant financial benefits for employee owners, with studies showing that ESOP participants generate more in wages and retirement assets than non-ESOP participants.

2. More transparency and empowerment. Employee ownership allows workers to be more invested — literally and figuratively — in the performance of your business. As a result, they gain deeper insight into how the company is being run and why decisions are being made.

3. Long term stability. A successful ESOP can help your employees build significant wealth as shares appreciate over time, which can lead to a better quality of life and potentially even early retirement. This is a huge incentive.

What are the advantages of an ESOP for startups and small businesses?

Traditionally, ESOPs have been popular with privately held companies in the manufacturing, construction, and professional services industries. However, as a startup or small business, you should not overlook the potential benefits of employee ownership.

Every business is different, of course, but ESOPs can provide significant advantages for your startup, such as:

• A sense of shared purpose. In most startups, there is a small core of people working extremely hard to make the company a success. ESOPs offer a viable reward for this hard work, as well as the added incentive of ownership. Shared entrepreneurship is likely to bond your team even further, and increase productivity as you all look for ways to grow your company.

• A succession plan. For small businesses, the founder is often the face of the company. You build your team around your vision, and when you eventually decide to step away from the company, the transition can be rocky. An ESOP allows you to step back at your own pace while letting your fellow owners take the reins.

• Additional capital. If employee owners are willing to contribute to the company by buying shares (or even taking lower wages in return for stock), then you can divert more resources to growing the company.

This doesn’t mean that an ESOP is the right course for all startups. For instance, you may not be allowed to set up an ESOP under your company’s current legal structure, or you may not have the cash to set up and manage an ESOP yet. Consider the impact of departing employees, too. If you have a small team and several employees leave at once, you may not be able to buy back all their stock without hurting your wider budget. 

For these reasons, it’s a good idea to consult with qualified advisors before you make any decisions.

Disadvantages of ESOPs

There may also be other challenges when setting up an ESOP. Consider the following:

• ESOPs need to be managed. The actual ESOP itself requires administration. This is usually managed by a trustee, which means payment fees, legal expenses, and other associated costs.

• Not all company cultures support employee ownership. If your company’s culture is authoritarian, or doesn’t encourage employee ownership, an ESOP may not work. ESOPs require a strong cooperative mentality and built-in values to be a success. 

• ESOPs require a strong leadership structure. If you decide to sell or leave your company, you need a strong management structure in place to manage your employee owners’ interests during and after the transition. 

• If you sell, you will only receive fair market value. If you decide to sell or leave, potential buyers only have to pay the market value of your business. If your company is highly sought after, prospective buyers may have otherwise been willing to pay a higher price. 

What is ESOP distribution?

ESOP distribution is when your employees are paid the value of their shares, either in cash, stock, or a combination of both. This usually happens when they leave your company. However, this process isn’t as simple as just paying out the full value of those shares all at once. 

This is because ESOPs are subject to vesting, which means your employees must have worked for your company for a specific amount of time before they’re able to receive a payout.

Payouts can also vary depending on how a worker leaves your company. For instance:

• If an employee retires, leaves due to disability, or dies, your ESOP will typically begin distributing the employee’s vested benefits over the next year (either in a lump sum or in multiple payments spread over five years).

• If an employee leaves voluntarily (i.e. for another job), the distribution of benefits can typically be delayed for up to six years (some plans allow the employee to opt for a later distribution date, such as retirement age).

Note that, in many ESOPs, employees who leave on bad terms (i.e. terminated employees) are not typically entitled to anything.

How does taxation differ by country for a global workforce?

If you have (or intend to hire) employees in other countries, you can still offer an ESOP. However, each country has different tax laws, and complying with them all can be tricky. As a result, many companies with an ESOP and a global workforce opt to pay cash bonuses or other equity tools instead.

With Remote, you don’t need to do this. We provide global HR solutions, such as an employer of record (EOR) service, which allows you to hire quickly and easily in other countries. But unlike many other EOR providers, we also:

• Advise you on the local tax consequences of ESOP distribution (in every country we support)

• Help ensure that you are filing the correct tax reporting paperwork

• Help you avoid tax penalties and potential legal headaches

As a result, all your employees can benefit from your ESOP, while your company stays compliant all over the globe.

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What happens to an ESOP when a private company is acquired?

If your company is acquired, there are several potential outcomes. The ESOP may remain in place, be absorbed into the acquiring company’s ESOP, or simply be terminated. It all depends on the structure of your plan. If the ESOP is terminated, all participants usually become vested and their distributions begin. 

During a merger or acquisition, it’s the trustee’s role to step in and make sure the new owners are abiding by your ESOP’s rules.

How are ESOPs regulated?

While you can tweak certain elements of an ESOP, they are still bound by government regulations. These rules differ by country, but generally cover the same areas. For instance, there may be contribution limits, documentation requirements, or minimum standards for investment plans.

Your ESOP must comply with the employee ownership rules of the country or region in which it is formed.

ESOP employee rights

When employees participate in an ESOP, they are granted certain rights. And as part owners of your company, they are entitled to key information about your ESOP.

In general, employees should have access to:

• Information about the plan

• An annual performance report

• Individual benefit statements

• Official plan documents

In most cases, you do not need to provide your employees with official company financial statements. However, in the interest of transparency, many companies opt to do this. 

Employees, as shareholders, are also given some voting rights. In private companies, ESOP participants usually have the right to direct the trustee on the voting of allocated shares for sale of all (or substantially all) the company's assets. In public companies, ESOP participants have the same rights as other shareholders. Participants are also entitled to information about the issues they will be voting on. 

How to calculate ESOP payout values

The stock prices on your plan’s individual benefit statements are usually determined by an independent, third-party appraisal firm (often chosen by the trustee). These valuation firms use several factors to determine the value of the ESOP shares, including your company’s income, your company’s assets, and market conditions.

If you want to get an idea of your ESOP’s payout values, you can use an online calculator. 

ESOP calculators

While there are no calculators that specifically cover early withdrawals, several calculators can help you and your employees understand how much they’ll accrue by a certain date: 

• CalcXML’s ESOP calculator: This solid, no-frills calculator uses employee information such as salary, projected growth, ESOP value, and stock prices to help determine a payout.

• Ian Tucker’s ESOP calculator: This detailed ESOP calculator breaks down payout by age.

• Certified EO’s ESOP calculator: This calculator uses visualization to show participants the expected growth of their payouts over time.

Setting up a global ESOP

As you can see, global ESOPs are a hugely effective way to attract and retain top talent, build a solid culture and sense of community in your company, and motivate your workforce.

But to set one up, you need intimate knowledge of the tax and legal regulations in the countries you’re hiring in. Finding and building a network of trustworthy local partners to support this can be time-consuming, and fraught with potential pitfalls.

This is why it’s a good idea to work with a reliable global services provider, like Remote. As well as providing qualified advice, our experienced equity experts can help you:

• Construct a global ESOP agreement

• Review your existing ESOP

• Understand local tax and regulatory implications

• Stay compliant with tax reporting requirements

If you want to learn more about how a global ESOP can support your incentives plan — and how Remote can help — then book a free consultation with one of our friendly experts today.

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