What is an ESOP?
Simply stated, an ESOP, or employee stock ownership plan, is a qualified defined-contribution benefit plan comprised of company stock, held by shareholders at a company (which is usually all vested employees). For the purposes of this website, however, an ESOP is a way to sell your company to your employees, enabling all employees to become shareholders in the company, and selling shareholders to obtain liquidity.
ESOPs are a great way to align the financial incentives and rewards of employees with those of ownership, as all employees will hold shares in the company.
Technically, ESOPs are a standalone entity (a trust), and the ESOP buys some or all of your company, and then issues shares to employees.
ESOPs work like this:
1. A company decides to sell some or all of its stock to an ESOP.
2. A valuation and formal sale process are undergone, where the business is valued, and a negotiation is held between the selling shareholders and the employees. Employees are represented by a trustee (a lawyer), who advocates on behalf of the employees for the purposes of the transaction, valuation, deal terms, etc.
3. Once terms are agreed to between selling shareholders and the third party trustee, a transaction is completed.
4. Sell shareholders receive liquidity for their shares, and employees become shareholders.
5. The business moves forward in this new operating state, with employees now having equity / stock in the company, and ownership having obtained liquidity (and in some cases, exited all together).
There are many nuances to an ESOP. For example, a company may choose to sell some or all of its stock to an ESOP. Some owners may choose to exit, where others may choose to stay on.
The point of this is that ESOPs are a highly customizable solution, and through exploration, an ESOP can be designed to meet any number of circumstances.
Criteria for an ESOP to work well:
1. Ownership is seeking liquidity.
2. Company has a well established culture, with employees that “buy in” to the company mission and core values.
3. Established management team that plays an active role in running the business (this doesn’t have to be formally established, or it could be partly established, however, the people who would comprise this management team need to be currently a part of the team)
4. Company is profitable
Situations when an ESOP doesn’t work well:
1. Company culture is not defined
2. Core values are “stock” and not modeled nor stitched into the fabric of the business
3. There is no management team — the company revolves around one owner
Read a bit more via our library of ESOP topics, as there is quite a bit more to explore, such as: