Forming a Company

ESOP Formation

Wondering how ESOPs work? We've got the scoop on how to form an ESOP and why so many startup business owners are doing exactly that.

Before you launch your business, you may want to learn about ESOPs.

ESOP Formation

Nearly 11,000 companies now have these plans, covering over 8 million employees. But the best part is that an ESOP can increase your profits and strengthen your business.

You might be surprised to learn that employees who work for companies with Employee Stock Ownership Plans (ESOPs), earn 3% or more of their total compensation from the plan. Yet employees aren't the only ones who appreciate the benefits of ESOPs. Business owners are acutely aware of the benefits of ESOPs, too - so much so that one out of every ten private sector employees now has the option of participating in an ESOP through their employer.

Some business owners use ESOPs to protect their business from takeovers. But the overwhelming majority of employers use ESOPs to reward employees, motivate their workforce, and create opportunities for employees to buy the business when the owner retires.

ESOP Mechanics

To establish an ESOP, the company establishes a trust fund containing shares of company stock. Individual employees are then allocated a certain number of shares based on their relative pay or some other method that is fair and equitable. It is fairly common for employers to establish a vested ESOP in which employees own a larger percentage of their shares the longer they work for the company. Most plans fully vest their employees within three to six years of the initial allocation.

When an employee leaves the company, the company purchases their accumulated shares at the vested level. The purchase price of employee stock is set by fair market value on the basis of annual third-party valuations (privately-held companies) or the current stock price (publicly-held companies).

Despite their appeal, there are a few things you need to know before you implement an ESOP in your company. ESOPs are almost universally offered to all of the companies employees. Discriminatory access to ESOPs can be problematic for a couple of reasons. First, it plants seed of dissension in the business as some employees benefit from the company's prosperity - and some don't. But perhaps more importantly, selective application can invite unwanted legal attention and leave your business vulnerable to litigation.

You should also know that, to a certain degree, ESOPs have a life of their own. One of the major consequences of an ESOPs pseudo-independent status is that possesses the ability to borrow money, usually for the purpose of purchasing new or existing shares of stock. The company, in turn, makes cash contributions to the ESOP so it can repay its debt. Under this arrangement, ESOPs are sometimes used to enable a transition of ownership from a retiring owner to the employees themselves. An added feature of these plans is that company contributions to ESOPs are usually tax-deductible.

Not all types of businesses qualify for ESOPs. For example, partnerships and other business structures may be restricted from utilizing certain features or prohibited from establishing an ESOP altogether. For most business owners, the best advice is to consult your attorney before sharing your intention to establish an ESOP within the company.

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ESOPs seem like a really smart way to align interests and take money out of the business. Do you agree? Please post your comments below.

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