How an ESOP Works
There are several ways through which employees can become the owners of their company, but the ESOP is the main source of employee ownership in the US. This is how it works.
In the US, the main form of ongoing employee ownership is the employee stock ownership plan (ESOP). An ESOP is a type of employee benefit plan that acquires company stock and holds it in accounts for employees. Many people have misconceptions about ESOPs, thinking, for example, that employees buy the stock or that an ESOP works like an equity compensation plan. The illustration below shows how an ESOP works in a typical case, where it is used to buy out the owner. There also are many ESOPs in public companies, where they often are a component of a 401(k) plan and a minor component of overall ownership, but the explanation here shows an ESOP in its most characteristic form.
ESOPs Step-by-Step
An ESOP lets employees own part or all of the company they work for. They build up shares in retirement accounts over time and cash them in when they leave without ever paying for the stock themselves. Here's how it works when Pat, a company owner, sells shares to an ESOP.
The company creates an ESOP trust
The trust is a legal entity that holds stock on behalf of employees. It follows many of the same rules as a 401(k) plan, but it is funded entirely by the company, not by employee paychecks.
Money flows into the trust
The company contributes cash to the trust, or the trust borrows money from a bank, the seller, or both. When borrowing is involved, as is common, it's called a leveraged ESOP.
The trust buys shares from the owner
Using that money, the trust purchases some or all of the company's shares from Pat. The price isn't guesswork; it's set by an independent appraiser.
Shares land in employee accounts
The trust allocates shares to employees' ESOP accounts. In a leveraged ESOP (where the plan borrows money), this happens as the loan is repaid. By law, shares are distributed according to relative pay, or by a more equal formula. Employees become owners without spending a dime.
Employees are paid when they leave
When employees leave the company, their shares are cashed out, providing a significant retirement benefit. And beyond any one person, the ESOP protects jobs by keeping ownership in-house and the company a going concern.
See what happened?
Employees now hold stock in their retirement accounts and are owners of the business, without ever making a cash outlay.
Pat found a buyer while keeping the business going, and she can keep working there and ease out in stages, if that's right for her and the company.
The infographic above is adapted from Employee Ownership: Building a Better American Economy, pictured at right. You can download this 24-page full-color PDF at no charge at nceo.org.