The employee stock ownership plan (ESOP) is best known as a valuable qualified retirement plan. But an ESOP can also serve as a powerful corporate finance tool.
How ESOPs work in retirement planning
ESOPs are qualified defined contribution plans, similar to 401(k) plans. What distinguishes ESOPs from other defined contribution plans is that, rather than investing in a selection of stocks, bonds and mutual funds, ESOPs invest primarily in the sponsoring company’s stock. Otherwise, ESOPs are subject to similar requirements as other qualified retirement plans, including contribution limits, minimum coverage standards, nondiscrimination rules and reporting obligations.
The sponsoring company makes tax-deductible contributions to the ESOP (subject to contribution limits), which uses the funds to acquire stock from the corporation or its current shareholders. The plan then credits stock to participants’ accounts, which grow on a tax-deferred basis. The ESOP distributes benefits in the form of stock or cash when participants retire, die, become disabled or terminate employment.
Like other qualified plans, an ESOP is a valuable benefit your company can use to attract and retain talented employees. In addition, because an ESOP invests in your company’s own stock, it serves as a powerful incentive to participating employees by aligning their financial interests with the company’s future performance.
How ESOPs serve as a financing tool
Companies can also use ESOPs as a potentially tax-efficient vehicle for raising capital. Unlike other qualified plans, a “leveraged ESOP” can borrow the funds it needs to acquire company stock.
What makes leveraged ESOPs advantageous? When your company borrows money, the interest payments are tax deductible. But when your company makes tax-deductible contributions to a leveraged ESOP to cover its loan payments, the company can effectively deduct both interest and principal. This enhances cash flow and generates more capital.
Your company can use the funds to retire existing debt, finance acquisitions or reorganizations, or provide additional working capital — or for virtually any other corporate purpose. In addition, by putting a significant portion of a company’s stock in the hands of your employees, an ESOP can help protect the company against hostile takeovers.
Consider the pros and cons
ESOPs offer many benefits, but you’ll need to consider some disadvantages as well. Like other qualified plans, ESOPs come at a cost, which reduces earnings. And ESOPs dilute the current ownership’s voting control. Also, by definition, ESOPs “put all their eggs in one basket.” So, they may present greater investment risk to employees than other qualified plans with more diversified investment portfolios. If your company is considering an ESOP, be sure to discuss the pros and cons with your advisors.