A Deep Dive into ESOP Plan Design: Part I

Four-Part Series by Vantage Point Advisors, Inc. | Jason M. Bolt, CFA, ASA & Rich Barth


Table of Contents 

The objective of this four-part series is to discuss some of the aspects of plan design management may consider when establishing an ESOP.

Part I:  ESOP Considerations

  • Introduction
  • ESOP Plan Considerations

Part II:  ESOP Considerations, Continued

  • Alternative Equity Compensation Plans
  • Preexisting Retirement Benefit Plan Considerations

Part III:  The Specifics of ESOP Design

  • Eligibility
  • Basis of Allocation of Contributions
  • Release of Shares from Suspense Account
  • Dividends and How Dividends Will Be Applied
  • Put Options

Part IV:  Leveraged ESOPs

  • Leveraged ESOPS
  • Vesting and Forfeiture
  • Conclusion

Part I:  ESOP Considerations


An employee stock ownership plan (“ESOP”) is a qualified, defined contribution employee benefit plan that invests primarily in the stock of the employer company.[1] An ESOP is established when a company creates a trust fund for the benefit of employees. The assets of the employee stock ownership trust (“ESOT”) are primarily the equity of a sponsor company but may include other investments and cash.

This article is Part I of a four-part series providing an overview of the process to establish an ESOP.  In Part I, we discuss ESOP plan considerations. In Part II we discuss some early pitfalls to consider to avoid issues later in the ESOP planning process.  In Part III we discuss some specifics of designing the ESOP.  Finally, in Part IV, we discuss leveraged ESOPs.

ESOP implementation can lead to information overload for anyone trying to understand it all at once. Throughout the ESOP planning process, communication is essential and early communication with employees is paramount to uncovering issues or employee misgivings and allowing management time to address any issues. Establishing a regular communication schedule and providing updates and new information on a regular and consistent basis is key to keeping all parties engaged.

Obtaining and incorporating input from employees is helpful in achieving buy-in on plan design. It is important, although often overlooked, that a company allow for enough time for all parties to become educated and develop an understanding of the process and expectations for the ultimate outcomes.  Employees should be comfortable with what to expect from an ESOP. Communicating the benefits of employee ownership to employees can be helpful both on an individual level and for a company as a whole.


Benefits of an ESOP

ESOPs may be attractive to companies and employees, and existing owners for a number of reasons, including: (1) tax benefits for the seller(s) and participants, (2) providing liquidity to owners of a closely held business, and (3) increased employee engagement. Multiple studies, such as the 2000 Rutgers University study and the 1986 National Center for Employee Ownership (“NCEO”) study, have shown employee ownership improves both employee motivation and corporate performance.

ESOP plans—when designed correctly—are customized to an individual company. As such, there is no one-size-fits-all ESOP plan and a company should undertake some initial factfinding before moving into any particular ESOP plan design. Companies should address areas that may cause confusion or conflicts with existing retirement plans down the road, and a recommended practice is to deal with these issues upfront. Taking the time to think through what a company should look like after an ESOP is in place before drafting any legal documents will help to avoid many pitfalls.


ESOP Plan Considerations

An early step in implementing an ESOP is designing the plan. But, some pre-planning can help management and the potential sellers decide if an ESOP is right for their situation, and, if so, implement the best plan for their circumstance.

Before designing an ESOP, a company needs to know if it is a good candidate for ESOP formation. Typically, companies that are capable of implementing and sponsoring a sustainable ESOP have the following characteristics:

  • Are closely held U.S. companies;
  • Have an established track record of consistent profitability;
  • Have one or more owners who are interested in a liquidation event and in a diversification of personal wealth;
  • Have one or more owners who are interested in ownership/management succession planning and in transitioning the ownership of the company to the employees; and
  • Have owners who are not seeking a strategic acquisition; Have a senior management team that supports the concept of an ESOP formation (and of the employee ownership of the sponsor company).

These characteristics may be used as a test for the suitability of an ESOP to a particular company, but no single criterion above is considered a so-called “must-have.” That being the case, if a company, its shareholders, and management do not conform to most of these criteria, then the company may not be a good candidate for an ESOP formation.

Additionally, companies and their owners should decide if an ESOP is right for them based on other factors such as willingness to sell and culture fit. It can be common for management to decide that an ESOP is a good fit, but the owners are unwilling to sell. If management proceeds with designing a plan under the assumption that the owners desire to sell, time and money may be wasted if the owners do not intend to sell the business in the near-term or are uninterested in selling their ownership interests to an ESOP.

After reaching an understanding with company ownership that an exit is desirable, the next step should be to conduct a feasibility study that should provide useful information to both the sponsor company shareholders and to the managers and directors about the financial practicality of an ESOP (see Part II:  Financial and Cash Flow Planning for more details of the application of a feasibility study).

In general, a feasibility study should assess:

  • How much extra cash flow a company has available to devote to the ESOP;
  • Whether a company has adequate payroll for the participants to make the ESOP contributions deductible; and
  • An estimate of the repurchase liability and how the company will meet its obligations.

Management should consider whether the company can afford to finance the ESOP—particularly if the ESOP is leveraged, as the company will be taking on additional debt for ESOP financing. Additionally, the other nondebt service ESOP-related costs such as administrative expenses, regulatory compliance expenses, and financial statement impact “costs” should be considered.

Next, a preliminary valuation should be conducted by an independent third party. This step can be critical in the process because it will provide an estimate of the sale price the sellers can expect to receive. If the value is too low, the seller may not be willing to sell. On the other hand, if the value is too high, the company/ESOP may not be able to afford financing payments. The preliminary valuation can help to form the basis of (1) projected annual debt service requirements, and (2) the projected repurchase obligation.

The next step is to hire an ESOP attorney.[2] After going through an initial planning process, a company should have the information necessary to draft a plan to submit to the IRS. An ESOP attorney is a critical member of an ESOP team and can help answer any plan questions the company has. Selecting a diligent attorney is crucial, as ESOP law and best practices are always evolving.

The initial planning will allow a company to create at least an outline of an ESOP plan. Having a plan framework for how a company wants the ESOP set up could save a considerable amount of money in consultation time. Copies of the appropriate ESOP plan documents should be filed with the IRS, along with IRS forms including 5301 and 5309 and appropriate fees. In most cases, it is not necessary to await a determination letter before beginning the ESOP operation, because any minor modification that the IRS may require can be made as a retroactive amendment to the plan.[3] This means that while the IRS may take months to issue a letter of determination on a plan, a company can begin making contributions in the meantime. It is very rare for the IRS to rule against a proposed ESOP.

At this point, a company will need to secure funding for the ESOP which may be in the form of (1) bank financing (2) seller financing, or (3) self-funding. Bank financing is usually an option to fund the ESOP transaction because banks are generally friendly toward ESOPs, and financing through banks can be cheaper than other options, such as seller financing.[4]

On the other hand, seller financing may provide more flexibility on terms and provide for tax advantages for the sellers, although it can be more expensive than bank financing. Seller financing may include both (1) interest expense on the seller’s note and (2) warrants which a company is typically required to repurchase from the sellers at some point in the future.

As a third alternative, a company can sponsor its own ESOP plan, which relies on company cash to fund an ESOP plan. Company sponsorship saves on interest expense, but results in a company incurring the opportunity cost of the funds not invested in other productive business operations.

The final source of funding, which is another form of self-funding, is through existing benefit plans. While pension plans are not a practical source of funding, profit sharing plans are sometimes used to transfer profit sharing assets into an ESOP. While many ESOPs do this, it must be done with caution. If employees are given no choice in the switch, there could be a securities law issue.[5]

Finally, it is time for to form the rest of the ESOP team. At this point, a company will select a trustee (either an employee or group of employees or an external trustee) who will oversee the ESOP trust and select the valuation firm for the transaction and ongoing valuations (note that the valuation firm selected for the initial ESOP transaction may not be the same valuation firm selected for the ongoing ESOP valuation updates).

An internal trustee is generally more cost effective, but cost is typically the only benefit of selecting an internal trustee. Choosing an external trustee increases the cost, but the external trustee brings greater expertise and an established network of other ESOP professionals to help ensure the ESOP is successful.

The trustee has a myriad of responsibilities, including voting on behalf of the ESOP participants,  tendering the ESOP shares, overseeing the valuation of the stock, being responsible for the investment of non-employer securities in the ESOP, and being generally responsible for the operation of the plan in the best interests of employees. Anyone can serve as a trustee, and there are no legal requirements for who selects the trustee—although the trustee is typically either an outside institution with trustee experience (like a bank or trust company), an officer of the company, or a trust committee made up of company officers and/or employee representatives. Due to the high level of scrutiny of ESOP transactions by the Department of Labor (“DOL”), there are substantial risks of being a trustee that internal trustees should evaluate with their corporate counsel and personal counsel. The trustee may be held liable for any over- or underpayment for ESOP shares and where an external professional trustee typically has the resources to defend themselves, an internal trustee likes does not have the same level of resources.


From here, a company considers plan administrators and establishes an ESOP committee. Usually, the committee will consist primarily of management, but the inclusion of non-managers on the committee can help drive employee engagement.

[1] Rodrick, Scott; An Introduction to ESOPs (Sixth Edition) (Oakland, CA: The National Center for Employee Ownership, 2004), pg. 1.

[2] “A Detailed Overview of Employee Ownership Plan Alternatives,” April 10, 2018, https://www.nceo.org/articles/comprehensive-overview-employee-ownership, pg 17.

[3]       Robert W. Smiley, Jr, Ronald J. Gilbert, David M. Binns, Ronald L. Ludwig, Corey M. Rosen, Employee Stock Ownership Plans (La Jolla, CA: the Beyster Institute at the Rady School of Management, University of California, San Diego, 2007) 7-6.

[4] “A Detailed Overview of Employee Ownership Plan Alternatives,” April 10, 2018, https://www.nceo.org/articles/comprehensive-overview-employee-ownership, pg 17.

[5] Scott Rodrick and Corey Rosen (Eds), The ESOP Reader (3rd edition) (Oakland, CA: The National Center for Employee Ownership, 2003) pg. 17.


If you’re looking for more information on business valuations or just need some advice, contact us today.

Contact Us

Jason Bolt is a Manager at Vantage Point Advisors, Inc. Portland office. During his tenure in the valuation profession, Jason has performed valuations of business entities for purchase price allocations (ASC 805), goodwill impairment testing (ASC 350), board advisory, tax reporting, and share-based compensation (IRC 409A and ASC 718).








Rich Barth is Managing Director at Vantage Point Advisors, Inc. He has compiled over 20 years of international investment banking and valuation experience at firms including Goldman Sachs, HSBC Securities and Houlihan Lokey.