You might have heard of employee stock ownership plans, but what exactly are they, and how do they work?

Our brief guide explains the basics…

What is an employee stock ownership plan?

An employee stock ownership plan (ESOP), also sometimes known as a stock purchase plan, is essentially a benefit plan that gives an ownership interest in the business to its employees.

It works by allocating shares to employees who are eligible for the scheme. The number of shares received by individual employees can vary depending on different criteria. This could be based on pay scale, role, or some other criteria for deciding share distribution.

There are some definite benefits in an ESOP, for both employers and employees, but there may also be some drawbacks.

The benefits of participating in an ESOP

One of the main benefits for the company providing the ESOP is that the workers who participate are likely to be more personally invested in the company. This can improve motivation, morale and performance – if an employee has a concrete stake in the company, then it is, after all, in their own best interests to help it to succeed and see its value increase.

Operating an ESOP can also sometimes help with employee retention as workers may be more likely to stay and continue to build up their shares.

The employees’ shares are generally held in a trust until the individual worker concerned either leaves or retires. At that point, they are free to sell the shares, either back to their former employer or on the open market. They are not taxed on the ESOP shares until they are sold, and even then, taxation can sometimes be deferred further if they reinvest in certain ways.

Additionally, employees generally have to work with the company for a given period of time before qualifying for the scheme.

Measurable benefits can often be seen for the company operating an ESOP. The National Center for Employee Ownership (NCEO) cited a study by Rutgers, which showed that companies with an ESOP in place grew 2.3% faster after setting up the scheme.

Potential drawbacks for employees

If the company performs poorly or suffers a setback, then employees who are participating in an ESOP could find their shares losing equity. This possibility is balanced, however, by the fact that employees at firms with an ESOP in place tend to receive higher employer contributions to their savings plans than employees at other companies.

Another potential drawback is that many employees who participate in this type of scheme will put all their investment eggs in one basket. In other words, they may rely on the ESOP as their main or only type of saving and are unlikely to have a very diverse investment portfolio. It’s worth remembering that most financial advisors would caution investors who sunk more than 10% of their total available assets in company stock, which can be unreliable.

How many employees operate ESOPs in the US?

The NCEO says that there are around 7,000 of these schemes currently being operated within the US, with an estimated 13.5 million workers participating in the ESOPs. There are also some other forms of employee ownership that are not the same as ESOPs. These include stock options and direct purchase plans. According to the NCEO, around 8% of total corporate stock is owned by employees through some sort of stock distribution scheme.

What you should know as a jobseeker

Questions about employee benefits can often be overlooked during the interview process, but it’s important to learn as much as you can about the benefit packages and schemes that are being offered. As well as finding out if you are a suitable employee, after all, the process should also help you to determine if the employer is the right fit for you. In some cases, an ESOP might not be the best option if it replaces other retirement benefits.

If you are offered a position, you should make sure that you know exactly how it works. Some important considerations to keep in mind are how the benefits will be paid out, how the scheme will be taxed, and the value of the stock on offer.