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

The concept of an ESOP was developed way back in 1916, but it only became a well-known option in the business world in 1974, when Congress passed the Employee Retirement Income Security Act (ERISA). ERISA established ESOPs as a type of tax-qualified program. Unlike other plans that seem to take sides and benefit either the employer or employees, ESOPs are 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

ESOPs are usually set up as trust funds that can be funded in several ways. The company can put in newly-issued shares, it can put in cash to buy existing company shares from public or private owners, or it can borrow money through the plan to buy company shares. In the latter case, the company then makes contributions to the plan so it can repay the loan. Company contributions to the fund are tax-deductible, up to a certain point.

Are ESOPs Right For Startups?

On paper, an ESOP is a type of stock ownership plan and can be used as part of a corporate-finance strategy. In real life, it’s much more than that. Companies that have ESOPs usually have a specific type of culture, one that is very open and transparent, that values employees, and believes in sharing information and wealth. In a sense, this is similar to certain startup cultures, which make the two quite compatible. Companies that have ESOPs need to explain to employees what it is they’re getting, and this requires a certain leveling of the playing field. Suddenly, it’s not only the CEO who is really invested in the future of the company; it’s the entire staff.

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.