What Is an ESOP?

An employee stock ownership program (ESOP) is a program that allows employees to purchase stock in the companies they work for. ESOPs can improve employees' work efforts, provide an incentive for employees to stay at a company, and allow retiring owners to transfer shares of stock to employees.

While ESOPs have many benefits, they aren’t cheap. Setting up an ESOP can cost tens of thousands of dollars for small- to medium-size companies, and administration fees typically range from $3,000 to $10,000 a year.

If you decide an ESOP is right for your company, you'll have to create a trust and make annual contributions to employees' accounts within that trust. By law, ESOPs must invest primarily in the securities of the sponsoring company. Like 401(k) plans, ESOP accounts receive tax-deferred status until the participating employee retires.

Companies that start ESOPs usually hire consultants to help them design their plans. Some of the decisions you and your consultant will have to make include:

• Who will be eligible to participate in the plan?
• How will the company allocate stock?
• What will the plan's vesting schedule be?

After you've decided on the features of your ESOP, your attorney must draft a document that outlines the plan's rules. You'll also need to choose a plan trustee and a plan administrator. Trustees can be staff members, such as a CEO, or external entities, such as a bank or trustee company.

When employees leave your company, they are entitled to the vested portion of their account. Employees of public companies simply retain ownership of their stock with the option of selling it on the open market.

If you own a private company, however, you’ll have to purchase ESOP stock from departing employees. This means your company must keep enough cash reserves to make these purchases. Private companies with ESOPs also need to hire independent appraisers to determine their stock value each year.