EMPLOYEE STOCK OWNERSHIP PLAN

Employee Stock Ownership Plan: Tempo Air Conditioning Company



Employee Stock Ownership Plan: Tempo Air Conditioning Company

Introduction

Employee ownership can be accomplished in a variety of ways. Employees can buy stock directly, be given it as a bonus, can receive stock options, or obtain stock through a profit sharing plan. Some employees become owners through worker cooperatives where everyone has an equal vote. But by far the most common form of employee ownership in the U.S. is the ESOP, or employee stock ownership plan. Almost unknown until 1974, about 11,000 companies now have these plans, covering over 13 million employees.

Companies can use ESOPs for a variety of purposes. Contrary to the impression one can get from media accounts, ESOPs are almost never used to save troubled companies—only at most a handful of such plans are set up each year. Instead, ESOPs are most commonly used to provide a market for the shares of departing owners of successful closely held companies, to motivate and reward employees, or to take advantage of incentives to borrow money for acquiring new assets in pretax dollars. In almost every case, ESOPs are a contribution to the employee, not an employee purchase.

What is an ESOP and how does it work?

As initially envisioned, ESOPs were intended to serve as an employee benefit program, whereby employees were given an ownership interest in the company as a retirement benefit, while at the same time creating an incentive for the employees to act in a way that was in the best interest of the company. While this remains one of the primary reasons for establishing ESOPs, the more common reason that ESOPs are created today is as a means for a retiring shareholder to sell his or her ownership in the business. So how does it work? When a company establishes an ESOP, it creates a trust that holds the shares of stock being purchased (or contributed) from either the company or the selling shareholder. The shares held in the trust are allocated to individual employees on a predetermined formula based on, for example, relative compensation, years of employment, or some combination thereof. “Ownership” of these shares by the individual employee is typically vested over a five to seven year period. When an employee leaves the company or retires, the vested shares in the employees account are distributed to the employee from the trust.

Depending upon the terms of the ESOP, the departed employee can either sell the shares back to the company (or on the public market if publicly traded) or hold on to them for disposition at a later date. Since this article discusses ESOPs as a means for a selling shareholder to exit the business, let's assume that the shares are sold to the ESOP by the selling shareholder (as opposed to being contributed by the shareholder or the company as an employee benefit). So where does the money come from to buy the shares? The money used by the ESOP to purchase the selling shareholder's ...