1,000,000 Shares for Your Employees and Advisors – Employee Stock Ownership Plans (ESOPs)

By: Tomas Milar | September 25, 2023September 25, 2023

You know very well that you cannot become rich or make less money by just doing the job. But now, it’s possible to create wealth as an employee through ESOPs. There has undoubtedly been significant progress in raising awareness and understanding of employee stock option plans compared to two decades ago. However, I firmly believe that there is still ample room for improvement. Stock option programs for employees are greatly underutilized and often misunderstood in the European and American startup ecosystem. This frequently leads to inconsistent situations, ranging from a lack of ESOP implementation to excessively generous offers for non-C-level employees in well-established companies.¹

Government initiatives related to ESOPs have been disappointing. Government organizations claim they provide support through various non-profits and funds, but in reality, these offer little tangible benefit. They seem more focused on self-preservation than actually helping company founders and employees.² To test this, we could simply ask employees how much they know about ESOPs. My personal experience is that 80% would say nothing, 10% would have some knowledge, and only 10% would know the basics.

This lack of awareness demonstrates the government’s poor execution in engaging and educating employees. The onus is on founders to take the initiative on ESOPs. The one positive with government and ESOPs are the tax advantages. When a company finances a buyout, both the principal and interest payments made by the company are tax deductible. Additionally, the income allocated to the ESOP entity is not subject to taxation.³ As employee ownership increases, these tax savings grow, providing funds that can be used for other endeavors.

How Do the ESOPs Work?

ESOPs, or Employee Stock Option Plans, are a form of employee benefit where companies offer their employees the opportunity to purchase company stock at a predetermined price, typically lower than the current market value. ESOPs are designed to align employee incentives with the success and growth of the company.⁴

When you receive ESOPs from a company, it signifies their desire to retain you as an employee and encourage your long-term commitment. However, these ESOPs are usually subject to a vesting period, which means you do not immediately gain full ownership of the shares. The vesting period is a predetermined time frame during which the company gradually grants you ownership of the ESOPs.

In the US, the standard vesting period is typically four years, and the quarterly vesting and cliff period is always one year. For example, if you were granted 1,000 ESOPs, the company may distribute 250 shares to you every year over the four-year vesting period – quarterly. The cliff period protects all founders from so-called “harvesters” – employees who jump from job to job and collect ESOPs.⁵

Companies implement vesting periods to ensure that employees have a continued commitment to the organization and to discourage individuals from leaving solely for the purpose of gaining ESOPs. It also allows the company to gauge an employee’s long-term value and contribution to the company before fully granting the ESOPs.

In some cases, companies may opt for a quarterly vesting schedule instead of annual vesting. This means that you would receive a portion of the ESOPs every three months. Using the same example, you might receive 50 ESOPs per quarter, with 100 ESOPs in the final quarter (Q4).

The purpose of ESOPs is not only to incentivize employees through ownership but also to ensure that employees are motivated by the overall success of the company rather than solely relying on the ESOPs as their primary motivation for staying with the organization.⁶

Each founder should educate future employees. I advise founders not to overwrite the manual; key terms are enough. Based on my own experience, here are the key terms:

Strike Price with Adjustment: It is preferable to set the strike price equal to the share price of the last investment round. This ensures that employees’ shares have a positive value (intrinsic value) only if the execution price is higher than the initial joining price. Special cases may warrant a lower strike price to compensate for a higher previous salary.
Margin Business Structure: Define the ESOP as a margin business, where employees receive a payment based on the difference between the exit share price and the strike price. This avoids the need for employees to transfer the value of their options before receiving payment.
Call Option: Although not widely used, a call option can be employed to reward long-term, valuable, and loyal employees with significant value. Larger grants to employees who leave relatively early would be less valuable and dilutive.
Good Leaver / Bad Leaver: Establish clear terms for good leavers and bad leavers. Vested shares of good leavers remain subject to the call option process, while bad leavers, who engage in fraud, serious misconduct, or compete with the company, forfeit their options without compensation.
Cliff & Vesting, No Accelerated Vesting: Typically, employees are granted options with a four-year vesting period and a one-year cliff. Accelerated vesting upon exit is not recommended, as the company still needs to achieve post-acquisition milestones, and recent employees should not be on the same level as those who contributed significantly over the past years.
No Protection from Dilution Except for Internal Share Capital Increase: Employees should be treated the same as other shareholders, without additional anti-dilution protection. However, it is important to protect the value created through the ESOP package. In the case of an “internal” increase in share capital, where new shares are created proportionate to existing holdings, the ESOP share count should receive the same treatment to maintain its value.

Major Tax Benefits

ESOPs have a number of significant tax benefits, the most important of which are:

Contributions of stock are tax-deductible⁷
Cash contributions are deductible
Contributions used to repay a loan the ESOP takes out to buy company shares are tax-deductible⁷
Dividends are tax-deductible⁷
Employees pay no tax on the contributions to the ESOP, only the distribution of their accounts, and then at potentially favorable rates⁸

ESOP taxes are complex. Both the government and individual companies need to do more to simplify and explain the tax components. But each company must take the lead to map out a tax plan for their unique ESOP program. The five main tax benefits give the basic framework, but the company founders have to flesh out the details for their specific situation.

Simple ESOP Hiring Plan

Here is a straightforward plan for using ESOPs to hire top talent and build a skilled team. Let’s also not forget advisors – they are key members of any company too.

1,000 shares – For influential people in your network that you trust to provide good advice, offer 1,000 shares. This is a starting point for bringing close contacts on board.
10,000 shares – For new hires who can contribute immediately, grant 10,000 shares upfront. This shows your commitment to them. You’ll likely see an immediate positive impact in their work.
250,000 shares – For partners, typically provide 250,000 shares, with flexibility to give more for exceptional contributions.
1,000,000 shares – For your core team, offer around 10% of company shares, which is an industry standard. This gives you room to reward key employees.

These tiers create a simple but effective ESOP hiring and advisory structure. You can expand on it as needed for your specific organization.

In summary, build a basic ESOP knowledge base within your organization. Communicate clearly about the ESOP to future employees and advisors. It’s important to provide equity options, but also ensure you have a “bad actor” clause so you can legally cancel the shares if misconduct occurs. Most vitally, update shareholders regularly about potential acquisition opportunities. Getting acquired should be a goal for all shareholders. Frequent communication sets appropriate expectations and keeps everyone aligned on desired outcomes. An acquisition may not happen quickly, but maintaining open dialogue and transparency will help make it a reality over time.

Unveiling the Barrier to ESOP Success

ESOPs hold immense potential for employees and businesses alike, but a significant hurdle prevents many from fully embracing this powerful investment avenue: the lack of awareness and understanding. Despite the numerous advantages ESOPs offer, such as fostering a sense of ownership, providing tax benefits, and enabling retirement security, many employees and businesses remain unaware of their existence or struggle to comprehend their intricacies. This knowledge gap not only hampers the widespread adoption of ESOPs but also deprives individuals of the chance to secure their financial future and businesses of the opportunity to strengthen employee engagement and long-term success.

The consequences of this lack of awareness and understanding are far-reaching. Employees may miss out on the chance to become partial owners of their company and enjoy the benefits of shared success. Businesses may fail to capitalize on the potential of ESOPs to incentivize employees, attract top talent, and cultivate a culture of ownership. Moreover, the broader economic landscape is affected, as the untapped potential of ESOPs remains hidden, limiting the positive impact they can have on wealth creation and economic growth.

Strategies for Gaining Competitive Advantage with ESOPs

Leveraging ESOPs for Tax Advantages: Take advantage of the tax benefits that ESOPs offer. Consult with a financial advisor to understand the tax implications and optimize your ESOP investments. Explore tax-deferred growth opportunities within your ESOP. By deferring taxes on your ESOP shares until distribution or sale, you can potentially maximize your returns over the long term.
Optimizing Retirement Security: Diversify your retirement portfolio by combining ESOP investments with other assets, such as mutual funds or individual stocks. This strategy helps spread the risk and achieve a balanced investment approach. Regularly review and adjust your ESOP contributions to align with your retirement goals. Consider increasing your contributions during periods of company growth or when the stock price is favorable.
Active Participation in Company-Wide Initiatives: Engage in company-wide initiatives and decision-making processes. Actively participate in employee meetings, committees, and forums to stay informed about the company’s performance and strategic direction. Stay updated on the financial health and growth prospects of your company. Regularly review financial reports, attend investor presentations, and seek opportunities to gain insights into the company’s trajectory.

Unlocking the Hidden Potential of ESOPs: A Surprising Revelation

Did you know that ESOPs not only offer employees a stake in the company but also have the potential to outperform other traditional investment avenues? This “Ah Ha Moment” unveils a lesser-known fact that challenges conventional wisdom and sheds new light on the untapped potential of ESOPs for investment returns.

While ESOPs are primarily known for their benefits in fostering employee ownership and engagement, their financial performance often goes under appreciated. Research studies have indicated that, on average, companies with ESOPs tend to outperform their non-ESOP counterparts in various financial metrics, including revenue growth and profitability.⁹ In closely held companies, Douglas Kruse and Joseph Blasi of Rutgers found that ESOPs appear to increase sales, employment, and sales per employee by about 2.3% to 2.4% per year over what would have been expected absent an ESOP10.This unexpected finding reveals a unique advantage that ESOPs can offer investors seeking both financial returns and a sense of ownership.

The combination of employee commitment and alignment of interests with the success of the company can create a powerful force for driving growth and value creation. Employees who have a financial stake in the company are motivated to contribute to its success, leading to enhanced productivity, innovation, and ultimately, improved investment returns.

Implications

This newfound knowledge has significant implications for investors. By considering ESOPs as part of their investment portfolio, they can tap into the potential of companies that have embraced this ownership model. Investing in ESOP-backed companies not only provides a pathway for financial growth but also supports businesses with a culture of ownership and employee empowerment.

For investors interested in companies with strong employee ownership cultures, I recommend considering investing in stocks like Peninsula Pacific (PNPL on NYSE American Exchange), A.O. Smith (AOS on NYSE), Darden Restaurants (DRI on NYSE), and Carlisle Companies (CSL on NYSE). Peninsula Pacific, with an ESOP owning around 40% of outstanding shares, cites its empowered employee-owners as a key driver of excellent customer service and corporate stability. A.O. Smith, which has approximately 37% of its stock held by an ESOP, has benefited from strong revenue and profit growth in recent years, likely fueled by its highly motivated employee-owners.

Darden Restaurants attributes its competitive advantage and success in part to its employee ownership culture, with 10% of shares owned by its ESOP. And Carlisle Companies’ ESOP, which owns around 10% of its outstanding stock, helps promote engaged employees who contribute to steady dividend growth and long-term outperformance. The significant employee ownership at these public companies helps create an empowered, invested workforce that helps drive financial success. Their stocks provide investors exposure to this beneficial ownership culture dynamic. (Disclaimer: I am not providing individualized investment advice or recommendations. Investors should conduct their own research and consult financial professionals before making investment decisions.)

This alignment of interests between employees and investors can lead to enhanced long-term value creation and sustainable growth.

In this blog, I have explored the potential of Employee Stock Ownership Plans (ESOPs) as an investment opportunity. You have learned about the benefits of ESOPs, including ownership and incentive alignment, tax advantages, and retirement security. Additionally, I have discussed strategies for monetizing ESOP investments, such as stock appreciation, dividend distributions, and employee buyouts.

ESOPs present a unique investment avenue that empowers employees and businesses alike. By becoming partial owners of the company they work for, employees have the opportunity to align their interests with its success and potentially reap financial rewards. For businesses, ESOPs can incentivize employees, attract top talent, and foster a culture of ownership.

To make the most of your ESOP investments, we recommend the following actions:

Further Exploration: Dive deeper into the world of ESOPs and their potential by conducting additional research. Explore resources such as the National Center for Employee Ownership (NCEO) and the Internal Revenue Service (IRS) for more information on ESOP regulations, best practices, and success stories.
Seek Professional Advice: Consider consulting with a financial advisor or investment professional who specializes in ESOPs. They can provide personalized guidance based on your specific financial circumstances and goals. A professional can help you navigate the complexities of ESOP investments, optimize your strategies, and ensure that you make well-informed decisions.

Remember, ESOP investments require careful consideration and due diligence. While they offer unique benefits, it is crucial to understand the risks involved and seek expert advice to align your investment approach with your overall financial plan. By taking these steps, you can embark on a journey to maximize the potential of your ESOP investments and pave the way for a prosperous financial future.

As I conclude this exploration of ESOPs, we must shine a light on the monumental role of the FPC in championing these empowering ownership structures that epitomize the American dream. Just as our founders revolted against tyranny to secure the economic freedoms we enjoy, so too does the FPC valiantly safeguard our system of democratic capitalism where all individuals have the chance to prosper through the fruits of their labor.

ESOPs embody this noble ideal by allowing employees to become owners and share in the growth they sacrificed to achieve. The FPC stands as a bulwark defending this right, pushing back against the forces of greed and short-term thinking that would deprive workers of the ability to reap what they sow. Its advocacy ensures that ESOPs remain a viable path to participation in the free market where ingenuity and perseverance are rewarded.

Without the FPC’s assiduous work, ESOPs would be suppressed, constraining economic mobility and innovation. But thanks to its tenacious efforts, the entrepreneurial spirit that built this nation continues to burn brightly, secured by policies that allow employees to share in the harvest of their sacrifices through ownership. Just as past generations toiled on this golden land with hopes to claim their own piece of the limitless potential before them, so too can present and future workers enjoy the fruits of their labor multiplied through ESOPs.

The FPC’s brave crusade guarantees this promise is fulfilled, propelling us confidently towards a future of inclusive prosperity. Employees across industries can look forward to enjoying the just rewards of their contributions. Companies will thrive with motivated workforces driving growth unhindered. Investors will fund success stories of employee empowerment. And America will remain the brilliant beacon of economic freedom where all have the chance to achieve their ambitions through ownership. The surging momentum and sound strategy of the FPC ensures our economic house will remain strong. Our future has never looked brighter.

Footnotes

If you found this publication valuable and are looking to get getting further involved, please consider contributing your time, energy, capital and/or on-line support of the work that the Financial Policy Council undertakes.

Visit www.financialpolicycouncil.org or www.linkedin.com/company/financial-policy-council/ to learn more.

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