How Do ESOPs Work?
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Rationale
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Congress adopted the Employee Stock Ownership Plan (ESOP) legislation in 1974 to encourage businesses to expand ownership to employees. The logic was that stock ownership by employees would reduce conflict with management, offer additional income from cash dividends and improve productivity of shareholding employees.
Structure
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An ESOP is basically a trust, wherein shares of the company are purchased in the name of employees and held by the trustee until employees retire or leave the company. The company either gives the trust money to buy more stock or issues new shares and places them under the control of the trust.
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Types
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There are two types of ESOPs, based on whether they include borrowed money. "Leverage" is the financial term for borrowing money to buy a company. In a non-leveraged ESOP, stock (or cash) is regularly contributed to the trust. The amount varies from year to year and is at the discretion of the employer. This is basically the same as other pension and benefit funds except that only the stock of the employee's company are purchased.
In a leveraged ESOP, shares are purchased with borrowed money. The money can be used to buy out existing shareholders or invested back into the business. When an ESOP loan payment is due, the company places money in the trust and the money is used to pay off the loan. As the loan is paid off, the stock is transferred to the accounts of individual employees and employee ownership increases over time.
ESOPs are considered an employee benefit and money invested in these programs is almost always in addition to regular pay. A typical company contributes between 5 to 15 percent to the plan each year.
Purpose
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An ESOP can serve several purposes for a company. It can be used as a succession planning tool where the ESOP buys the shares of a retiring shareholder. ESOPs can also be used to buy or sell a subsidiary, buy back outstanding shares in the market or change the employee benefits structure.
ESOPs can be used to buy newly issued shares and the company can use the proceeds for any business purpose. Finally, ESOPs provide a means of liquidity for shareholders of closely held companies.
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