Employee Stock Options and Ownership (ESOP) (Encyclopedia of Business)
Employee stock ownership occurs when the people who work for a corporation hold shares in that corporation. In general, management experts believe that turning employees into shareholders increases their loyalty to the company and leads to improved performance. Stock ownership also offers employees the potential for significant financial rewards. For example, workers in several fledgling high-technology companies have become millionaires by purchasing stock at the ground floor and then watching the market price rise astronomically. Employee stock ownership takes a number of different forms. Two of the most common forms are stock options and employee stock ownership plans, or ESOPs.
EMPLOYEE STOCK OPTIONS
Stock options give employees the right to purchase a certain number of shares in the company at a fixed price for a given period. The purchase price, also known as the strike price, is usually the market value of the stock on the date that the options are granted. In most cases, employees must wait until the options are vested (usually four years) before exercising their right to buy shares at the strike price. Ideally, the market value of the stock will have increased during the vesting period, so that employees are able to purchase shares at a significant discount. The difference between the strike price and the market price at the time the options are exercised is the employees' gain. Once employees own stocks rather than options to buy stocks, they can either hold the shares or sell them on the open market.
At one time, stock options were a form of compensation limited to top executives and outside directors. But in the 1990s, fast-growing high-technology companies began granting stock options to all employees in order to attract and retain top talent. The use of broad-based stock option plans has since spread to other industries, as various kinds of businesses have tried to capture the dynamic atmosphere of the high-tech companies. In fact, according to U.S. News and World Report, more than one-third of the nation's largest companies offered broad-based stock option plans to employees in 1999ore than twice the number that did so as recently as 1993. In addition, the amount of total corporate equity held by nonmanagement employees increased from between 1 and 2 percent in the early 1980s to between 6 and 10 percent in the late 1990s. "In the rampaging, skills-hungry global economy of the 1990s, employee stock options have become the new manna widely accepted means of attracting and retaining key workers," Edward 0. Welles wrote in Inc.
ADVANTAGES AND DISADVANTAGES OF STOCK OPTIONS
The most commonly cited advantage in granting stock options to employees is that they increase employee loyalty and commitment to the organization. Employees become owners with a financial stake in the company's performance. Talented employees will be attracted to the company, and will be inclined to stay in order to reap the future rewards. But stock options also offer tax advantages to businesses. Options are shown as worthless on company books until they are exercised. Even though stock options are technically a form of deferred employee compensation, companies are not required to record options pending as an expense. This helps growth companies to show a healthy bottom line. "Granting options enables managers to pay employees with an IOU rather than cashith the prospect that the stock market, not the company, will one day pay up," Welles explained. Once employees exercise their options, the company is allowed to take a tax deduction equal to the difference between the strike price and the market price as compensation expense.
But critics of stock options claim that the disadvantages often outweigh the advantages. For one thing, many employees cash out their shares immediately after exercising their option to buy. These employees may want to diversify their personal holdings or lock in gains. In either case, however, they do not remain shareholders very long, so any motivational value of the options is lost. Some employees disappear with their newfound wealth as soon as they cash in their options, looking for another quick score with a new growth company. Their loyalty lasts only until their options mature.
Another common criticism of stock option plans is that they encourage excessive risk taking by management. Unlike regular shareholders, employees who hold stock options share in the upside potential of stock price gains, but not in the downside risk of stock price losses. They simply choose not to exercise their options if the market price falls below the strike price. Other critics claim that the use of stock options as compensation actually places undue risk upon unsuspecting employees. If large numbers of employees try to exercise their options in order to take advantage of gains in the market price, it can collapse an unstable company's whole equity structure. The company is required to issue new shares of stock when employees exercise their options. This increases the number of shares outstanding and dilutes the value of stock held by other investors. To forestall the dilution of value, the company has to either increase its earnings or repurchase stock on the open market.
In an article for HR Magazine, Paul L. Gilles mentioned several alternatives that solve some of the problems associated with traditional stock options. For example, to ensure that the options act as a reward for employee performance, a company might use premium-price options. These options feature an exercise price that is higher than the market price at the time the option is granted, meaning that the option is worthless unless the company's performance improves. Variable-price options are similar, except that the exercise price moves in relation to the performance of the overall market or the stocks of an industry group. To overcome the problem of employees cashing out their stock as soon as they exercise their options, some companies establish guidelines requiring management to hold a certain amount of stock in order to be eligible for future stock options.
EMPLOYEE STOCK OWNERSHIP PLANS
An employee stock ownership plan (ESOP) is a qualified retirement program through which employees receive shares of the corporation's stock. Like cash-based retirement plans, ESOPs are subject to eligibility and vesting requirements and provide employees with monetary benefits upon retirement, death, or disability. But unlike other programs, the funds held in ESOPs are invested primarily in employer securities (shares of the employer's stock) rather than in a stock portfolio, mutual fund, or other type of financial instrument.
ESOPs offer several advantages to employers. First and foremost, federal laws accord significant tax breaks to such plans. For example, the company can borrow money through the ESOP for expansion or other purposes, and then repay the loan by making fully tax-deductible contributions to the ESOP (in ordinary loans, only interest payments are tax deductible). In addition, business owners who sell their stake in the company to the ESOP are often able to defer or even avoid capital-gains taxes associated with the sale of the business. In this way, ESOPs have become an important tool in succession planning for business owners preparing for retirement.
A less tangible advantage many employers experience upon establishing an ESOP is an increase in employee loyalty and productivity. In addition to providing an employee benefit in terms of increased compensation, as cash-based profit sharing arrangements do, ESOPs give employees an incentive to improve their performance because they have a tangible stake in the company. "Under an ESOP, you treat employees with the same respect you would accord a partner. Then they start behaving like owners. That's the real magic of an ESOP," explained Don Way, chief executive officer (CEO) of a California commercial insurance firm, in Nation's Business.
In fact, in a survey of companies that had recently instituted ESOPs quoted in Nation's Business, 68 percent of respondents said that their financial numbers had improved, while 60 percent reported increases in employee productivity. Some experts also claim that ESOPsore so than regular profit sharing plansake it easier for businesses to recruit, retain, and motivate their employees. "An ESOP creates a vision for every employee and gets everybody pulling in the same direction," said Joe Cabral, CEO of a California-based producer of computer network support equipment, in Nation's Business.
GROWTH OF ESOPS
The first ESOP was created in 1957, but the idea did not attract much attention until 1974, when plan details were laid out in the Employee Retirement Income Security Act (ERISA). The number of businesses sponsoring ESOPs expanded steadily during the 1980s, as changes in the tax code made them more attractive for business owners. Though the popularity of ESOPs declined during the recession of the early 1990s, it has rebounded since then. According to the National Center for Employee Ownership, the number of companies with ESOPs grew from 9,000 in 1990 to 10,000 in 1997, but 60 percent of that increase took place in 1996 alone, causing many observers to predict the beginning of a steep upward trend. The growth stems not only from the strength of the economy, but also from business owners' recognition that ESOPs can provide them with a competitive advantage in terms of increased loyalty and productivity.
In order to establish an ESOP, a company must have been in business and shown a profit for at least three years. One of the main factors limiting the growth of ESOPs is that they are relatively complicated and require strict reporting, and thus can be quite expensive to establish and administer. According to Nation's Business, ESOP set-up costs range from $20,000 to $50,000, plus there may be additional fees involved if the company chooses to hire an outside administrator. For closely held corporationshose stock is not publicly traded and thus does not have a readily discernable market valueederal law requires an independent evaluation of the ESOP each year, which may cost $10,000. On the plus side, many plan costs are tax deductible.
Employers can choose between two main types of ESOPs, loosely known as basic ESOPs and leveraged ESOPs. They differ primarily in the ways in which the ESOP obtains the company's stock. In a basic ESOP, the employer simply contributes securities or cash to the plan each yearike an ordinary profit-sharing plano that the ESOP can purchase stock. Such contributions are tax-deductible for the employer to a limit of 15 percent of payroll. In contrast, leveraged ESOPs obtain bank loans to purchase the company's stock. The employer can then use the proceeds of the stock purchase to expand the business, or to fund the business owner's retirement nest egg. The business can repay the loans through contributions to the ESOP that are tax-deductible for the employer to a limit of 25 percent of payroll.
An ESOP can also be a useful tool in facilitating the buying and selling of small businesses. For example, a business owner nearing retirement age can sell his or her stake in the company to the ESOP in order to gain tax advantages and provide for the continuation of the business. Some experts claim that transferring ownership to the employees in this way is preferable to third-party sales, which entail negative tax implications as well as the uncertainty of finding a buyer and collecting installment payments from them. Instead, the ESOP can borrow money to buy out the owner's stake in the company. If, after the stock purchase, the ESOP holds over 30 percent of the company's shares, then the owner can defer capital-gains taxes by investing the proceeds in a qualified replacement property (QRP). QRPs can include stocks, bonds, and certain retirement accounts. The income stream generated by the QRP can help provide the business owner with income during retirement.
ESOPs can also prove helpful to those interested in buying a business. Many individuals and companies choose to raise capital to finance such a purchase by selling nonvoting stock in the business to its employees. This strategy allows the purchaser to retain the voting shares in order to maintain control of the business. At one time, banks favored this sort of purchase arrangement because they were entitled to deduct 50 percent of the interest payments as long as the ESOP loan was used to purchase a majority stake in the company. This tax incentive for banks was eliminated, however, with the passage of the Small Business Jobs Protection Act.
In addition to the various advantages that ESOPs can provide to business owners, sellers, and buyers, they also offer several benefits to employees. Like other types of retirement plans, the employer's contributions to an ESOP on behalf of employees are allowed to grow tax-free until the funds are distributed upon an employee's retirement. At the time an employee retires or leaves the company, he or she simply sells the stock back to the company. The proceeds of the stock sale can then be rolled over into another qualified retirement plan, such as an individual retirement account or a plan sponsored by another employer. Another provision of ESOPs gives participantspon reaching the age of 55 and putting in at least ten years of servicehe option of diversifying their ESOP investment away from company stock and toward more traditional investments.
The financial rewards associated with ESOPs can be particularly impressive for long-term employees who have participated in the growth of a company. Of course, employees encounter some risks with ESOPs, too, since much of their retirement funds are invested in the stock of one small company. In fact, an ESOP may become worthless if the sponsoring company goes bankrupt. But history has shown that this scenario is unlikely to occur: only 1 percent of ESOP firms have gone under financially in last 20 years.
WHO SHOULD ESTABLISH AN ESOP
In general, ESOPs are likely to prove too costly for very small companies, those with high employee turnover, or those that rely heavily on contract workers. ESOPs might also be problematic for businesses that have uncertain cash flow, since companies are contractually obligated to repurchase stock from employees when they retire or leave the company. Finally, ESOPs are most appropriate for companies that are committed to allowing employees to participate in the management of the business. Otherwise, an ESOP might tend to create resentment among employees who become part-owners of the company and then are not treated in accordance with their status.
[Laurie Collier Hillstrom]
Folkman, Jeffrey M. "Tax Law Change Boosts Usefulness of ESOPs." Crain's Cleveland Business, 22 March 1999.
Gilles, Paul L. "Alternatives for Stock Options." HR Magazine, January 1999.
James, Glenn. "Advice for Companies Planning to Issue Stock Options." Tax Adviser, February 1999.
Kaufman, Steve. "ESOPs' Appeal on the Increase." Nation's Business, June 1997.
Lardner, James. "OK, Here Are Your Options." U.S. News and World Report, I March 1999.
Shanney-Saborsky, Regina. "Why It Pays to Use an ESOP in a Business Succession Plan." Practical Accountant, September 1996.
Welles, Edward 0. "Motherhood, Apple Pie, and Stock Options." Inc., February 1998.