Employee Ownership: ESOP Pros and Cons
December 18, 2017
There are roughly 7,000 employee stock ownership plans (ESOPs) covering about 14 million employees, according to the National Center for Employee Ownership (NCEO). An ESOP is a type of retirement plan that invests primarily in company stock and holds its assets in a trust. This is the main vehicle for broad-based ownership in the United States.
The following sections explore employee ownership and ESOPs.
What Is Employee Ownership?
Employee ownership is the direct or indirect ownership of a company, in part or in whole, by some or all of its employees. While a business owner can also be an employee, employee ownership refers to a broad cross-section of employees through a formal plan offered by the employer.
There are two main categories of employee ownership, according to the NCEO.
- ESOPs: Companies set up a trust fund for employees and then contribute cash to buy company stock, contribute shares directly to the plan or have the plan borrow money to buy shares. In the latter scenario, the company makes contributions to the plan to enable it to repay the loan. Contributions to the plan are tax-deductible, and employees pay no tax on the contributions until they receive the stock when they leave or retire. At that point, they sell it on the market or back to the company.
- Equity Compensation: This other category refers to a grant of stock or its equivalent from the employer. There are several types of equity compensation plans. Stock options give employees the right to buy company stock at a specific price and period. An employee stock purchase plan is similar, giving employees the chance to buy stock, typically through payroll deductions and at a discount. Restricted stock plans grant or sell employees stock once certain restrictions are met (such as vesting). Companies may also offer an unrestricted direct grant of shares. Other types of equity compensation include phantom stock plans and performance shares. Phantom stock plans provide a cash bonus based on a company’s stock value, but there is no actual grant of shares. Performance shares refer to equity compensation grants that pay out only when certain targets are met.
There are other less common types of employee ownership plans. 401(k) plans can offer company stock as an investment alternative and/or as a company match, and they can be combined with an ESOP (sometimes called a “KSOP”). Worker cooperatives refer to enterprises solely owned and governed by their workers.
ESOP Pros and Cons
One of the most obvious advantages for ESOPs is tax incentives. ESOPs enable business owners to avoid or defer capital-gain taxes.
“Strong tax incentives that help moderate large capital gains tax consequences help steer many founders and entrepreneurs towards ESOPs,” Mills Snell, partner at business advisory firm Pendleton Street Advisors, said in a Forbes article. “The ESOP borrows cash, which it uses to buy company shares or shares from existing owners,” added Loren Rodgers, executive director of the NCEO. “The company then makes tax-deductible contributions to the ESOP to repay the loan, meaning both principal and interest are deductible.”
Perhaps the most impactful advantage for ESOPs is how they can enhance company culture. “Everyone wants informed, engaged, innovative employees, but the data show that all of those practices are especially effective in employee-owned companies,” according to Rodgers. “There’s a synergistic effect between employee-ownership and engagement.” Rodgers pointed to data showing how employee-owned companies have higher rates of sales growth, employment growth and productivity, as well as lower turnover. “It just makes sense. When employees benefit from making the company stronger by owning shares, they have a reason to be better stewards of the company’s success.”
While ESOPs can be powerful in incentivizing employees and for gaining tax incentives, companies must be careful not to view them as a one-size-fits-all solution. ESOPs are not for all businesses.
Owners may need to wait years for gaining financial independence with an ESOP in place. Taking on debt or otherwise securing the capital to set up an ESOP can take its toll on the company. “While an ESOP can create liquidity for an owner that is otherwise heavily concentrated in the business, it can also potentially defer an owner’s overall timeline for exiting the company because either they, or the ESOP, will substantially guarantee the liabilities associated with the change in ownership- either through bank financing or the owner holding a seller’s note,” Snell said.
If companies aren’t careful, they may not be able to buy out employees when they retire, especially if they retire in waves. It takes time to plan a successful ESOP. Even choosing one can take a long time; it’s a significantly longer-term process than selling the business to an outside buyer.
Examples of Employee Ownership
Publix is the largest employee-owned company in the world. It has more than 175,000 workers and 1,110 store locations, with 24 new stores opening each year, according to Fortune. The company has appeared on Fortune’s 100 best companies to work for list since it began in 1998. The annual voluntary turnover rate at Publix is 5 percent, compared to the retail industry average of 65 percent.
One of the reasons for Publix’s high employee engagement and long-term success is its employee ownership plan, which was established in 1972. Employees who have worked for one year at the company and 1,000 or more hours are awarded stock valued at an average of 10 percent of their compensation. They receive annual allotments after that and have the option to purchase more shares.
In addition to regular reviews, frequent raises and a promote-from-within culture, Publix’s employee ownership plan has helped to create famous levels of employee and customer satisfaction.
King Arthur Flour
King Arthur Flour began by importing flour to Boston from Britain in 1790. Based in Norwich, Vermont, King Arthur Flour now supplies flour, ingredients, cookbooks, baking mixes and baked goods.
Since 2004, the company has been 100 percent employee-owned. Employees who have worked at King Arthur Flour for one year and log more than 800 hours a year are eligible for the ESOP. This includes seasonal and part-time laborers.
“King Arthur Flour has experienced major growth since it became employee-owned,” according to The New York Times. “In the late 1990s, the company started distributing products outside New England, to the Midwest and beyond, growing from a small regional business into a national one with robust sales. Its annual sales are now more than $100 million. More than 2,000 King Arthur Flour products are sold in grocery stores, to bakeries and through the company’s website and catalog.”
Considerations for Starting an Employee-Owned Business
Entrepreneur presented four steps for starting an employee-owned business.
- Plan your exit. Considering what will happen five, 10 and 20 years down the line can prevent a great deal of stress on you and your company. Employee ownership offers a way for you to keep the company that you built independent and for your corporate mission to stay intact.
- Open the books. Corporate transparency helps. ESOP companies should start treating employees like owners before actually making them owners. Current employees can receive training on financial topics and access to sales and financial figures. Including employees on big corporate initiatives can also prepare them for ownership.
- Hire with future partners in mind. Rethink the hiring process. Employee-owned businesses are not merely hiring employees, but potential business partners. Find people who you can imagine sharing ownership in the company.
- Cultivate a culture of democracy. The most successful employee-owned businesses encourage staff to help make big decisions. It’s not only good for employee morale, but the overall company.
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