ESOP: A Viable Option for Retaining Key Employees?
Companies are faced with an increasingly competitive job market and they need to be smart about the benefits they offer employees to ensure the best talent stays in the business. The competitive job scene has given rise to many employee benefit systems that look to keep employees motivated and feel financially rewarded. One such scheme is the employee stock ownership plan (ESOP), which has often been hailed as the best way to provide financial incentives for employees.
We’ll explore what ESOPs are all about and how the scheme can be used in the company. We’ll then look deeper into the benefits and drawbacks of using the scheme as an option for retaining key employees, before focusing on the conditions that are required for ESOPs to work.
In this article, you will learn 1) what ESOP means, 2) the uses of ESOP, 3) the advantages and 4) disadvantages of ESOPs in retaining employees, 5) best situations for ESOPs, and 6) a conclusion.
WHAT IS AN ESOP?
An employee stock ownership plan, or ESOP, is an employee-owner program which is widely used in a number of different countries around the world. ESOP provides a person working in the company an ownership interest in the company in the form of stock shares.
The ownership of the stocks usually comes with no up-front costs, although ESOPs will, in most instances, be part of the total remuneration for the work performed.
The shares, which are part of the ESOP, are typically held in a trust and will be sold once the employee either retires or leaves the company. The profits are then provided to the owner of the shares, i.e. the employee.
There are some differences in the way ESOPs are used depending on the type of company in question. There are further differences between countries. ESOPs were originally created in the US, as American companies wanted to encourage capital expansion and economic equality. Since then the use of ESOPs has moved beyond the US and many countries now use employee stock ownership plans to boost employee satisfaction.
It is important to note that while ESOP schemes give the employee shares in the ownership of the company, it doesn’t typically give them a say in how the company is run. Therefore, the scheme only acts as a financial incentive or a benefit, not an actual vote in matters relating to the business side of the company.
Each country also has their own specific laws and regulations regarding the intricate details of ESOPs. While the basis behind the plan remains the same around the world, there are finer differences in how ESOPs are taxed and what conditions need to be met before the scheme can be set up. It is always advisable to share your company’s plans with a special adviser to ensure you follow the rules of your country.
It is important to note that there are alternatives to using ESOPs. Some of the most common schemes include:
- Stock options – the biggest difference between stock options and ESOPs is the ability to have a say in some matters of running the company.
- Direct purchase plans – employees can buy stock with their own money
- Phantom stock – provides the employee with a future cash bonus similar to the value of owning shares
- Cooperatives – employees join the membership of owning the company and they’ll then receive a vote in the company. This scheme can also include members that do not work at the company.
THE USES OF ESOP
ESOPs can be used in a variety of different ways and many companies have their own unique reasons for setting up the scheme. There has previously been plenty of focus on using ESOPs as a way to save troubled companies, but this isn’t as commonly used as many people might think.
In general, ESOP use falls under one of two categories: a way to finance the growth of the company or a way to provide more benefits for employees to act as incentives.
In more detail, this means that ESOPs can be used in the following ways:
Buying the stock of a retiring owner
Many companies use ESOP as a financing method, especially in situations where the majority shareholder is leaving the company. In this instance, the retiring majority shareholder or owner sells the stock to an ESOP.
This provides the majority shareholder a means to enjoy tax incentives for the sale and provides more security and financing for the company and its employees.
Financing expansion by borrowing
Furthermore, companies can use the ESOP scheme to borrow money for the company. ESOPs can borrow money more easily and in most instances can do so while enjoying tax deductions on interest payments!
Creating an additional employee benefit
But using an ESOP as an additional employee benefit is perhaps the most common use of the scheme. By providing the employee with direct ownership of the company, many argue the employee will be more devoted and interested in ensuring the company succeeds.
Studies have been keen to back ESOP as a successful employee benefit, especially in terms of retaining an employee. The Gene ral Social Survey done in the US found in 2012 that employees participating in an ESOP scheme were four times less likely to be laid off than employees that had no ESOP scheme in place.
Furthermore, a previous 2010 study by the same organization found that 13% of employees with ESOPs were planning to walk out of the company they were in, while 24% of employees with no ESOPs planned to do the same.
You can find out about one company’s experience with ESOPs from the YouTube video below:
THE ADVANTAGES OF ESOPs IN RETAINING EMPLOYEES
It’s time to delve more deeply into the benefits of ESOPs, especially in terms of retaining key employees in the company. What are the benefits of an ESOP that could offer an incentive for an employee to stay with the company long-term?
The most common benefits of ESOPs include the following:
1) Tax advantages and other financial rewards
While an ESOP provides great financial benefits for the owners of the company and the company itself, the financial benefits for the employee are also great. Therefore, most companies use the financial benefits as an incentive for employees. Simply put, if you enjoy a financial reward for remaining with your company, you are less likely to walk away.
The biggest tax benefit for employees is how the ESOP can grow without any tax burden for the employee. This is enhanced by the fact that an employee can transfer an ESOP to another retirement plan without any additional tax payment on this distribution. Considering that the employee has not paid anything to participate in the scheme, this can act as a powerful incentive.
Additional financial rewards might also be included. The employee might receive extra bonuses through the ESOP scheme, if the company results are good.
2) Incentive-based retirement to attract employees
Most of us are looking forward to a relaxing retirement; although employees are becoming increasingly aware of the need to plan their retirement well to guarantee it is a financially secure one. As ESOPs come at no extra cost to the employee, they are considered a great way to add more financial security to one’s retirement.
Furthermore, it adds an incentive for the employee to work harder. If the company can provide the employee with a well-thought ESOP, it also takes away the burden of planning from the employee. This can be a great motivator for many employees, as it gives them more peace of mind about the future.
3) Morale boost and sense of ownership
ESOP schemes are good at providing employees with a deeper sense of ownership in the company. Naturally, as the employee now has an actual monetary stake in the company, there are more incentives to ensure the company succeeds as well.
This alone can help motivate the employee and act as a morale booster. While the well-being of the company is naturally important to all employees (for fear of losing one’s job), an extra monetary incentive enhances employee motivation.
4) Improves communication as both benefit
Sometimes problems in companies come down to poor communication, as employees are often unaware of the ‘bigger picture’. While ESOP schemes don’t require the company’s management to share too much detailed information about the company financials, employees participating in ESOPs are guaranteed to be informed about the overall health of the company.
An ESOP scheme automatically enhances communication, as it forces both the management and the employee to share information. Improved communication can lead to changes in the way the company operates and can help the company overcome any problems that may arise.
THE DISADVANTAGES OF ESOPs IN RETAINING EMPLOYEES
While the above shows there are plenty of benefits to ESOPs, it is important to also understand the disadvantages of running the scheme. When it comes to retaining employees at the company, some of the points below might be a deterrent for an employee:
1) Difficulties getting access to full amount
First, it is crucial to note that obtaining access to the full amount can sometimes be a slow process for the employee, as well as provide problems for the company. This can be a big hindrance to employees, although it is mainly a problem for retiring employees.
The difficulties arise when the company has to repurchase the ESOP shares from the retiring employee. If the company doesn’t have the funds available to do this, they might offer a payment plan or the employee might even have to hold on to the shares to overcome the funding problem. These options might be more risky for the employee and the financial benefit won’t be realized as quickly as the employee might have hoped.
2) The employee stands to lose if the business gets into trouble
All investors know you should never put all of your eggs in one basket, and an ESOP scheme unfortunately can do this. Many employees have nearly all of their retirement plans resting on the ESOP scheme and this poses a huge financial challenge.
If the company fails or falters, the employee won’t have any protection for the losses they might incur. Although the employee has not had to pay anything for the shares, they might still be relying on the financial gain and therefore, changes in the share price could have a huge effect on the financial security of the employee. While ESOPs in many instances can boost employee morale, if the employee has all eggs in one basket with the ESOP, potential troubles with the company could in turn dampen employee morale.
It is therefore crucial to make sure the ESOP is an additional financial scheme for the employee, and companies should instruct employees to have other retirement saving schemes in place as well.
3) No influence over the financial benefit
Finally, the employee might feel quite limited in terms of their influence over the financial benefit. While ESOPs can boost employee morale, improved work morale doesn’t automatically mean the share price of the company is going to go up.
The share price of a company is determined by many different factors and the employee might feel his or her work doesn’t have a real impact on the price. Therefore, they might feel they have no influence on the financial benefits ESOPs may provide.
Considering the effect the most recent financial crash had on people’s confidence in the markets, a financial incentive reliant on market performance might not sound as appealing to employees as it might have a few decades ago.
This together with the other issues mentioned can make ESOPs seem unappealing and employees might be more inclined to opt for a different type of financial benefit. It is therefore crucial to find a way to overcome these concerns if a company wants to run an ESOP scheme.
THE BEST SITUATIONS FOR ESOPs
As mentioned, ESOPs have plenty of advantages, but there are some downsides to using them as well. Also, it is important to note that not all companies are suitable for running an ESOP scheme.
The companies that would enjoy the most benefits from ESOPs and in turn could provide advantages to their employees should have the following characteristics:
- A privately owned business – Although it isn’t a legal requirement, privately owned businesses would make the most of ESOPs. This is due to public companies suffering more from the increase in retirement expenses and reduced earnings.
- A strong cash flow and history of increasing profits – If the company has a very volatile earnings pattern, the ESOPs won’t be such an attractive opportunity for employees. Furthermore, if the business has to lower employee wages because of cash flow problems, the contributions to ESOPs will also suffer.
- A strong management team – If you are looking to use ESOPs, you want to create a strong management culture in your team. This boosts shareholder confidence and will be beneficial for cash flow, and therefore will improve the future payments for employees.
- A diverse group of shareholders – You don’t want all the shareholders in the company to be in the same retirement age range, as this means you’ll need to sell a large portion of shares at the same time. Companies with a diverse workforce and shareholder group will enjoy ESOP benefits more.
- A higher income tax bracket – Finally, interestingly companies with a higher income tax bracket can make the most of ESOPs. This is due to the fact that the tax-deductible benefits will be stronger in these companies.
The above characteristics are not going to guarantee your company can make the most of ESOPs, but they generally tend to be important for success. If you keep the above in mind when deciding on your ESOP plan, you can make the use of ESOPs a viable option.
Furthermore, as the above has shown, many of the advantages are due to proper planning. If the ESOP scheme is properly planned and implemented, the company can ensure the disadvantages of ESOP are also limited. It might take the company some extra resources, but a well-planned ESOP will provide more benefits to both the company and the employee and show the employee the company has their best interest in mind.
ESOPs are an increasingly popular way to offer something extra for employees. While they are definitely a popular option with plenty of benefits to offer for both employees and the company, you should also be aware of the possible drawbacks. It is vital that any ESOP scheme used by a company is properly planned and administered.
While ESOPs can be a great financial incentive for an employee and can help retain key employees in the company, the scheme should never be used as the only benefit system. ESOPs could be a great part of an overall benefits package that helps the employee to feel appreciated and appropriately rewarded at the company, but a company shouldn’t rely solely on ESOPs to keep employees motivated.
Your company’s structure and future prospects can all influence the way ESOPs work and it’s a good idea to consult an ESOP specialist before implementing this scheme in your business.
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