An ESOP is a plan that gives employees a financial stake in the company they work for. ESOPs provide managers an incentive to maximize the shareholders’ funds and align their interests with those of other shareholders.
There are two types:
1. LEVERAGED ESOP
A leveraged ESOP is established when the sponsoring firm obtains credit to form an ESOP trust. The loan is repaid using employer contributions to the scheme and dividend shares, money is distributed in the employees’ accounts.
2. NON-LEVERAGED ESOP
A non-leveraged ESOP is established when the sponsoring firm contributes cash or stock (newly issued or treasury stock) to the plan. The adoption of either a non-leveraged or a leveraged ESOP can increase or decrease the company‘s cost of capital.
HOW ESOPs WORK
ESOPs are comparable to profit-sharing plans in certain aspects. In an ESOP, a company establishes a trust fund for its employees, who either contribute cash to purchase the company’s inventory, contribute shares directly to the scheme, or have the plan borrow funds to procure company shares. When the plan borrows funds, the company must make contributions to facilitate the plan in repaying the borrowed funds.
Company contributions to the trust are tax-deductible, subject to certain limitations, regardless of how the plan obtains stock. Shares in the trust are allocated to individual employee accounts. Employees receive their stock when they leave the firm, which the firm must purchase back at fair market value (unless there is a public market for the shares).
Employees can purchase stock directly, get stock as a bonus, earn stock options, or acquire stock through a profit-sharing plan. Employee cooperatives, in which everyone has an equal vote, allow certain employees to become owners.
The company appoints a trustee (or trustees) to hold the shares in trust for the employees who are eligible. Shares or units in the trust are subsequently distributed to individual employee accounts on a predetermined vesting date, according to the terms of the ESOP’s trust deed.
Allocations are determined based on relative pay or any other method that is preferred. Through a process known as vesting, employees have a growing entitlement to the shares in their account as their seniority within the firm grows.
This refers to the time between the date of the employer’s offer and the date on which the employee can exercise the option to purchase. Vesting is conditional on the employee being employed by the employer at the time of vesting. The shares can either be vested all at once (cliff vesting) or over time.
Contact us at advisory.sib.co.ke for a more tailored and in-depth discussion of how an ESOP can benefit your company.