ESOP Association Blog
Employee Ownership Options
There are a variety of ways to enable employees to become owners in the businesses where they work. These options generally aim to achieve three things:
- Reward employees financially.
- Encourage employee retention.
- Encourage employees to be loyal to the business and to pursue the company’s interests.
As one might expect, these options have pros and cons that make them better suited to some situations than others. Below is a brief analysis of some of the key differences between these common employee ownership options:
- Worker cooperatives.
- Employee stock ownership plans (ESOPs).
- Employee stock options (ESOs).
- Employee stock purchase plans (ESPPs).
Cost to Employees
Of the four options listed above, ESOPs are the only one that typically requires no out of pocket investment from employees. In an ESOP, the company pays for all shares and holds them on behalf of employees.
Coops require new members to buy in to the group; the amount needed to purchase a stake in the company will vary.
ESOs and ESPPs enable employees to buy shares at reduced rates. By their nature, they require employees to spend their own cash to purchase shares. Technically, there is one exception to this rule, and it occurs when an employee exercises an ESO and sells those shares immediately.
Employees have good reasons for taking this path: They know exactly how much profit they will make, and they eliminate any risk associated with holding a stock that may decline. Flipping shares immediately will, however, increase the employee’s tax liability.
From the employer’s perspective, there is a greater potential problem: When employees sell their stock immediately, they no longer own shares that align their interests with those of the business.
Long Term Incentives
In coops and ESOPs, employees cash out of their shares only when they leave the business. As a result, these forms of employee ownership have the longest term effect on retaining, rewarding, and incentivizing employees.
Coops and ESOPs also provide shorter term incentives because both plans provide annual incremental gains to employees.
In coops, annual surpluses may be allocated to members’ accounts, providing recurring positive reinforcement of employees’ efforts on behalf of the business.
In ESOPs the company stock must be valued each year, and when it is employees have a chance to see increased value on the shares they already own. They also have the chance to gain additional shares each year, thereby multiplying their gains.
Perhaps as importantly, ESOPs and coops encourage long term, ongoing commitment to the business because the stake employees own today could continue to increase in value as the company continues to perform well.
There is no such ongoing commitment with ESOs and ESPPs, which are limited term arrangements focused more on helping employees cash in on current gains seen to this point, rather than producing new ones.
In both ESOs and ESPPs, employees would be motivated to buy company stock only if they can do so at a good price. That price is determined within a set window of time, so that ESOs and ESPPs by definition do not function well as very long term incentives.
Perhaps as importantly, the primary motivation with ESOs and ESPPs is centered on making profit for the individual, not the company. Because individuals have purchased shares at a discount, they already have realized a profit and are therefore much more motivated to sell the shares and capture those gains. Once those shares are sold the ongoing connection to the company—and its performance—is severed.
In ESOPs and coops, profit for the company and the individual are linked: When the company performs well, employees benefit. This is true for as long as employees remain in the ESOP.
ESOs and ESPPs have no governance implications. The employees who participate in these programs own the same shares of stock as someone who has no connection to the business whatsoever.
Coops offer the greatest possibility for involvement in governance. Coops focus on democratic ownership in which each member of the coop gets one share and one vote. Members vote on key decisions, including electing the board of directors.
ESOPs are required to involve participants in voting on options, but only in select instances that include mergers, consolidations, liquidation, and others. Some ESOP companies—such as AMSTED Industries—choose to involve ESOP participants in broader governance efforts, such as electing members of the board.
All ESOP participants also enjoy another governance related perk: The ESOP is a trust that holds shares of the company stock, and the trustee is legally obligated to operate with the best interests of the shareholders—the employees—in mind. Thus, when the company makes decisions, the trustee may intervene on behalf of the employees.
Number of Shares
ESOs and ESPPs limit the number of shares employees may purchase through these arrangements. An additional limiting factor may be the size of employees’ bank accounts. Employees who are wealthier may be able to avail themselves of all the options offered to them, while lower paid employees may not have the means to exercise all of their available options.
Because coops emphasize democratic governance, each member of the coop gets one share (which corresponds to that person’s one vote).
At ESOPs, employees gain shares based on a number of factors that typically include tenure. Employees who stay with the company are rewarded with additional shares each year. The result: Long tenured employees may be able to amass impressive retirement accounts.
In a hearing of the House Committee on Education and the Workforce, Rep. Brett Guthrie (R-KY) mentioned a grocery store with an ESOP where employee owners needed financial counseling because their standard of living is set to increase in retirement.
ESOs and ESPPs enable employees to potentially realize an immediate gain by buying stock at a price lower than its current face value. For both plans, employees may need to pay tax immediately on the gains they realize from buying the stock.
With both arrangements, employees also incur taxes on the gains they realize upon selling their shares. How much tax employees pay may be determined by when they sell their shares. Shares that are held long enough may incur a lower rate than those that are sold more quickly.
Coop members also can incur annual taxes on the amounts allocated to their accounts—despite the fact that members may not actually have access to these funds. For this reason, coops often are required to pay some of the annual allocation to coop members in cash, to help them pay their taxes.
Because ESOPs are retirement plans, the funds in these accounts are not immediately taxed. As long as employees hold the ESOP account, or roll funds from an ESOP account into another retirement vehicle (such as an IRA), they avoid taxes. It is only when employees withdraw funds—hopefully when they are retired, so they can maximize this benefit—that they are taxed.