Is an ESOP the Right Choice for Your Startup?

Understanding ESOPs and Whether They’re Right for Startups

Every year, more than half of Fortune Magazine’s 100 Best Companies to Work For is made up of companies that have ESOPs, employee stock ownership plans, and other employee ownership plans. ESOPs are a type of benefit that gives employees ownership interest in the company. At the same time that ESOPs give employees stock, companies use them as part of their corporate-finance strategy. It’s a way of making sure the interests of the employees and those of the shareholders are aligned, since an ESOP essentially creates shareholders out of employees.

ESOPS: Mutually Beneficial

Employee benefits include the opportunity to get stocks, usually in a closely held company. Furthermore, employees aren’t taxed on their shares until they leave the company or retire. At that point, they have the option to sell the shares back to the company or to the open market. In addition, ESOPs offer better retirement returns than most retirement plans.

Companies can enjoy several benefits as well. ESOPs are often created to sell stock from a departing owner. Employees provide an audience for that stock. According to a 2000 Rutgers study, companies with ESOPs grow 2.3% to 2.4% faster after setting up an ESOP. The reason for this is the alignment of employee and company goals. Employees who have stock invested in the company will do their best to make it succeed. Employee retention also goes up in companies that have ESOPs since employees have so much invested in the companies. Last but not least, ESOPs offer various tax benefits.

The main downside of an ESOP is that it costs a lot of money to set up, which may be challenging for businesses that don’t have a large cash-flow. Additionally, certain business entities, like professional corporations and partnerships, are not authorized to set up an ESOP.

How It Works

Are ESOPs Right For Startups?

Startups that don’t operate on an open, employee-centric culture may have a harder time carrying out an ESOP. An ESOP, ultimately takes all of the shares from one centralized leader and distributes them among employees. It places the future of the company in the hands of its employees, which means that no one person is in full control. Startups with C-suite leaders who need to be in control may have a hard time coming to grips with the idea of an ESOP.

One other note to mention regarding ESOPs and startups is that the former allows startups to compensate their employees in a way that doesn’t involve paying out extra cash for salaries. In other words, companies can offer increasing shares in an ESOP as opposed to a raise. In startups, employees are more likely to go for this option than they are in established companies, that is if the startup is successful or if they believe it is on an upward trajectory towards success.

One thing is certain: ESOPs are not easy to pull off. They shouldn’t be considered as a quick fix for boosting company morale or determining company succession. While they can address both of those issues simultaneously, setting them up is a complex process, and sometimes requires a shift in the company’s mindset. If your startup is considering offering ESOPs, make sure to go about it with care and under the guidance of a corporate financial advisor, preferably one who is familiar with the world of startups.

Angel investor, entrepreneur, professional diver and passionate cook. My Medium blog in Russian: https://medium.com/@gilsmolinski/