A Deep Dive into ESOP Plan Design: Part 4

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 IV:  Leverage and Vesting

Leveraged ESOPs

A sponsor company will have to decide if creating a leveraged ESOP—using debt to buy company shares—is appropriate for its specific situation.

When a sponsor company agrees to borrow through an ESOP, it is allowed to deduct entire loan contributions (both principal and interest) made to the ESOP, with certain payroll-based limits.[1] Suffice it to say that the ability to deduct principal payments in addition to interest payments can have meaningful effects on cash flow and valuation. In addition, if a sponsor company is a C corporation it can deduct dividends paid on the shares acquired with the proceeds of the loan that was used to pay the loan itself.

On the other hand, the downside of borrowing to purchase shares for a company ESOP is the contributions by a sponsor company to an ESOP become less flexible because of an ESOP’s loan repayment obligations.

While banks generally view ESOPs favorably, securing financing may be difficult. The inability to secure financing usually results from one or more of the following:[2]

  • High leverage or limited debt capacity that restricts a company’s flexibility in adopting a leveraged ESOP.
  • Lack of mezzanine financing or seller support via a guarantee.
  • Inconsistent historical operating cash flows.
  • Insufficient cash flows to service debt obligations, or projected cash flows that rely on a “hockey stick” projection to service the ESOP debt (“hockey stick” projections are predictions of future performance that contain unprecedented or unsupported increases in sales, margins, and so on).
  • Insufficient tangible assets (for example, as may occur with a service company) exist to secure an ESOP loan obligation, or asset appraisals are well below the owner’s expectations.

Vesting and Forfeiture

Vesting refers to the amount of time an employee must work before acquiring a nonforfeitable entitlement to his or her benefit.[3] Some ESOP participants are likely to be unfamiliar with the vesting and forfeiture definitions and process. Clear communication of what vesting is, how it works and how it will impact an employee’s account balances is important to employee understanding and buy-in. It’s important to communicate to employees that those employees who leave the company before being fully vested will forfeit their unvested benefits. A couple simple numerical examples can help employees understand the impact to their share ownership balances should they leave the company within a certain number of years from the initial vesting date.

Careful planning is necessary, as vesting schedules and the treatment of forfeitures will impact the cash needs of an ESOP plan.

An ESOP must comply with one of the following two minimum schedules for vesting (plans may provide different standards if they are more generous to participants):[4] (1) no vesting at all in the first three years, followed by a sudden 100 percent vesting after not more than three years of service (“cliff” vesting); or (2) twenty percent vesting after the second year of service, with an additional 20 percent in each year until 100 percent vesting occurs after the sixth year of service (“graded” vesting). A “year of service” generally refers to a plan year in which a participant has 1,000 hours of service which may include past service.

The policy around forfeitures may impact ESOP planning. A forfeited share is not a liability unless an employee is rehired. While delaying the reallocation of forfeited shares may help manage a repurchase obligation, if a plan is terminated, forfeited shares may need to be repurchased.


Designing an ESOP takes careful planning and foresight. While the steps are straightforward, the considerations and specifics of the design process need to be fully understood and weighted carefully before moving forward. There are many issues for a company to consider when designing an ESOP, including ESOP eligibility, the basis of allocation of contributions, the release of shares from a suspense account, how dividends will be applied, and vesting and forfeiture. Other considerations include preexisting plan considerations, communication with employees, financial and cash flow planning, future ESOP purchases, and other plan design issues. A company that analyzes all of the considerations should be able to create a highly individualized company ESOP that works for the good of a company and its employees.

The primary purpose of the ESOP design process is to avoid potential problems in the future. For instance, if a company were to design an ESOP without carefully going through a thorough planning process, it could face a myriad of unexpected risks. One risk is that the implementation of the ESOP may fail due to the inability to agree on a sale price for the shares owned by the current owners. Another risk is that poorly performed feasibility studies could impact the ability of a company to analyze the affordability of an employee stock option plan. A poor initial valuation could result in two potentially disastrous effects: (1)  an unwilling seller and/or (2) a company unable to afford future repurchase obligation payments (due to projecting a repurchase obligation on too low of an initial share price). Finally, if a company fails to consider all factors in selecting a qualified trustee, it could leave an ESOP lacking in expertise or left without a partner to help navigate the nuances of a new ESOP.

A company that carefully performs the ESOP design process should be able to avoid these risks and create an ESOP that benefits the employees, management, and stakeholders of a company.


Link to Part I

Link to Part II

Link to Part III



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

Robert F. Reilly and Robert P. Schweihs, Best Practices (Ventnor City, New Jersey: Valuation Products and Services, LLC, 2019) 683 – 687

Internal Revenue Manuel Part 4, Chapter 72, Section 6 IRC 415,  https://www.irs.gov/irm/part4/irm_04-072-006 (FIX THIS)

“ESOP Vesting, Distribution, and Diversification Rules,” National Center for Employee Ownership, October 3, 2014, https://www.nceo.org/articles/esop-vesting-distribution-diversification

“Dividends and Employee Ownership,” National Center for Employee Ownership, April 5, 2012, https://www.nceo.org/articles/dividends-employee-ownership

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

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) 33-12 & 33-13

* IRC 410(b) (2) (A); Treas. Reg. 1.410(b)-4

Revenue Act of 1978 141; IRC 409(h)

Kober, John A. “Best Plan Practices.” Insights (Winter 2006):46-49

Scott S. Rodrick (Ed), Leveraged ESOPs and Employee Buyouts (5th edition) ((Oakland, CA: The National Center for Employee Ownership, 2005) 1-13

[1] “A Detailed Overview of Employee Ownership Plan Alternatives,” April 10, 2018, https://www.nceo.org/articles/comprehensive-overview-employee-ownership, pg. 5.

[2] Scott Rodrick and Corey Rosen (Eds), The ESOP Reader (3rd edition) (Oakland, CA: The National Center for Employee Ownership, 2003) pg. 63.

[3] “ESOP Vesting, Distribution, and Diversification Rules,” National Center for Employee Ownership, October 3, 2014, https://www.nceo.org/articles/esop-vesting-distribution-diversification, pg 1.

[4] Ibid.


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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.