A Deep Dive into ESOP Plan Design: Part 2

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 II: ESOP Considerations, Continued

In Part I, we discussed some considerations to be contemplated in the early stages of ESOP formation. In Part II, we discuss common alternatives to ESOPs and some potential pitfalls in plan design that, with some early forethought, may be avoided.

Alternative Equity Compensation Plans

Typically an ESOP is considered by existing owners as a way to liquidate their ownership positions and diversify their wealth holdings. The sponsor company may consider an ESOP mainly to get equity ownership into the hands of its employees. While a tax-qualified ESOP brings excellent benefits for employees, a company may consider the advantages and disadvantages of other equity compensation plans before establishing an ESOP. These plans might include (1) stock appreciation rights, (2) qualified and non-qualified stock purchase plans, stock option and bonus plans, and (3) qualified retirement plans or stock bonus programs, to name a few.

Compared to an ESOP, there are benefits and drawbacks to each of these plans. Possible issues to consider when selecting an equity-based compensation plan are:

  • Whether participation in the equity-based compensation plan should be company-wide or whether there is a desire to limit participation to certain employees,
  • Whether dilution of current ownership is permissible or desirable,
  • Tax benefits or considerations, and
  • Impact on cash flow.

Stock Appreciation Rights and Phantom Stock Plans

Stock appreciation rights (“SARs”) and phantom stock plans are both essentially cash bonus plans, although some SAR or phantom stock plans pay out the benefits in the form of shares of equity.[1] Neither of the plans provide the special tax benefits of an ESOP. Both SARs and phantom stock are considered to be synthetic equity plans, meaning that total ownership percentages are not impacted and related participants do not get to vote in corporate matters.

Stock Purchase Plans

Stock purchase plans include non-qualified direct stock purchase plans and Internal Revenue Code (“IRC”) 423 employee stock purchase plans.[2] Non-qualified direct stock purchase plans are simply a direct offer of shares for sale to the employees of a company. The stock price may be set at fair market value or at a discount, with the discount being tax-deductible to the sponsor company. Employee stock purchase plans (often called Section 423 plans or ESPPs) allow employees to put aside portions of their paychecks to buy company stock, typically at a discount. To qualify as an IRC 423 plan, the opportunity to purchase stock must be available to virtually all of the full-time employees of a company.

Stock Bonus Plans

A stock bonus plan is a defined contribution plan in which assets are generally invested in employer stock. The assets are held in a trust for employees, and the level of employer contributions does not necessarily depend on profits and maybe in either cash or stock. Technically, all ESOPs are stock bonus plans, but not all stock bonus plans are ESOPs. Employers who have difficulty with non-leveraged ESOPs because of legal and regulatory restrictions sometimes find it more convenient to adopt a stock bonus plan. In this case, where the employee has the option to receive distributions in the form of employer stock, the plan does not have to be invested in employer stock at any minimum level. A stock bonus plan is categorized under qualified employee benefit plans, along with 401(k), profit-sharing plans, and money purchase pension plans.

Non-qualified Equity Compensation Plans

Non-qualified equity compensation plans include direct stock grants, restricted stock grants, and the IRC 83 plan.[3] Direct stock grants are one of the simplest yet most flexible ways to provide employees with an ownership stake in a company and are usually tailored to reward performance. Restricted stock grants place restrictions on the award of stock, which defers any tax liability until the restrictions lapse and an employee acquires full rights to the award. For example, it is common to have a multi-year vesting schedule to give an employee a financial incentive to stay with a company.

Finally, stock option plans include incentive stock options (ISOs) and qualified stock options.[4] Both non-qualified stock grant plans and stock option plans provide the benefit of flexibility in determining which employees are granted ownership interests. Incentive stock options grant an employee the right to purchase employer securities at a predetermined price. When using an ISO, an employee pays no regular income tax at the time of the grant or exercise and instead pays capital gains tax when the stock is sold. Nonqualified stock option plans (NSOs) are any stock option plans that do not qualify for the favorable tax treatment provided by ISOs. Typically, NSOs offer more flexibility since they can be issued to non-employees of the sponsor company, while ISOs are only able to be granted to employees and provide tax savings to employees through the conversion of income to capital gains.


The prior discussion focused on alternatives to ESOPs, but the benefits and drawbacks of any stock-based compensation plan depend on the specific needs and wants of the sponsor company in question. Next, we discuss considerations of implementing an ESOP in connection with already existing compensation plans or retirement plans.


Preexisting Plan Considerations

Depending on the new plans implemented and how they interact with the ESOP, preexisting plans can impact administrative burdens. If a company is operating multiple plans, Section 415 of the Internal Revenue Code limits benefits allocated to individual employees’ accounts.

Having multiple plans with different limitation years can cause a violation, so it is best to keep all limitation years defined identically in all plans. Companies also need to consider addition and contribution limits. For example, ESOP payroll deduction limits can be affected by the other plans in place. In addition, employee deferrals into retirement plans and other employee contributions to other plans (retirement, stock bonus or profit-sharing) affect contribution limits.

Financial & Cash Flow Planning

As part of a feasibility study process as discussed previously, we recommend that a sponsor company spend time understanding financial feasibility as part of an initial ESOP plan discussion. Financial feasibility such as cash flow impacts, debt funding and other issues should be analyzed through projected financial statements. Ideally, an integrated three-statement financial projection should be prepared that includes, at a minimum, a projection of an income statement, capital expenditures, and working capital needs. Such financial statements and projections should help a company understand the limits and deductibility of ESOP contributions.

Company projections should be achievable while not being overly optimistic. Overly optimistic projections can lead to a false sense of security in meeting funding obligations, while overly- pessimistic projections can understate value growth and lead to a poor understanding of future repurchase obligations. Other cash flow considerations include cash needs to support growth, risk inputs, industry type (e.g. cyclical vs defensive), and a repurchase obligation which is typically low early in the life of an ESOP and increasing later in the selected projected period.

Other feasibility study considerations should include:[5]

  • A thorough analysis of both pre- and post-transaction values
  • Forecasts of the effect of the intended transaction on employees’ accumulations and other benefit plans of the employer
  • Forecasts of the effect of the intended transaction on the seller and any other shareholders
  • Analysis of the implication of the ESOP transaction on the governance of the corporation
  • Analysis of the specific communication requirements presented by your employee group

Future ESOP Purchases

In the instances of a partial ESOP purchase, it is important to understand the impact on the remaining (non-selling) shareholders. If an ESOP is leveraged, the equity value of the shares owned by the remaining shareholders can (and probably will) decrease. Understanding the desire for future exit plans of the remaining shareholders and the timing of those plans is necessary. Communicating the potential issues of selling interests to the ESOP after the first ESOP transaction, such as a lower price per share, is important. The decline in share price is usually expected to be short-lived, all else equal. Independent valuation professionals or ESOP consultants can help with this issue early on in the process of an ESOP design.

Other ESOP Plan Design Issues

Other ESOP plan design issues to consider require an understanding of the relevant corporate governance structure.

An ESOP, as a shareholder, is usually a majority shareholder or at least a significant shareholder. Taking the time to understand how an ESOP may impact corporate governance (such as voting in shareholder issues and electing board members) and staying up to date on retirement plan governance procedures is important.

It is helpful to understand if any corporate procedures need changing to reflect the changes due to an ESOP. In publicly traded ESOP companies, participants must be able to direct the trustee on how to vote the shares in their accounts on all shareholder issues. This includes electing the boards of directors, voting on major corporate decisions, and voting on shareholder resolutions that have been submitted.  Whether or not the employees will have a role in corporate governance is a major concern for business owners when setting up an ESOP. In practice, the large majority of ESOP companies end up being governed similarly to how they were governed before, as most owners worry that the ESOP will give employee-owners too much power.[6] ESOP rules and regulations require only nominal employee control rights, although results have tended to be positive when companies voluntarily go beyond this.


[1] “A Detailed Overview of Employee Ownership Plan Alternatives,” April 10, 2018, https://www.nceo.org/articles/comprehensive-overview-employee-ownership, pg. 26.

[2] 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) 33.4[4].

[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) 33.4.

[4] 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) 33.6.

[5] Scott Rodrick and Corey Rosen (Eds), The ESOP Reader (3rd edition) (Oakland, CA: The National Center for Employee Ownership, 2003) 15-17, 87-93.

[6]  Scott Rodrick and Corey Rosen (Eds), The ESOP Reader (3rd edition) (Oakland, CA: The National Center for Employee Ownership, 2003) pg. 157.



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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.