Employee ownership in the United States comes in several forms, including worker cooperatives, direct purchase plans, and stock-based compensation, but this website focuses on the most common form of employee ownership in the United States: the employee stock ownership plan, or ESOP.
Congress created the legal framework to encourage ESOPs in 1974 because its members believed that ESOPs could achieve a number of policy objectives. They expected that ESOPs would create a broader distribution of wealth, especially to the benefit of workers who otherwise would have only limited financial assets. Congress also expected ESOPs to improve company performance and to provide a way for owners of closely held companies to preserve their business legacy rather than closing or selling to an outside buyer.
Congress’s expectations have largely been borne out. The number of unique companies with ESOPs has grown to around 6,500. Although ESOPs fulfill many purposes simultaneously, understanding how they work depends on keeping their two distinct functions in mind.
Function 1. ESOPs are employee benefit plans.
ESOPs are company-sponsored employee retirement plans governed by the 1974 Employee Retirement Income Security Act (ERISA), the same law that governs 401(k) plans. Many ESOP features are intended to ensure that they are managed properly and fairly for all participants. By law, ESOPs must be broadly inclusive and allocate benefits to employees on a more level basis than typical 401(k) plans or non-ESOP stock compensation plans. Companies with ESOPs tend to have additional retirement plans, usually 401(k) plans, and on average they make larger contributions to employee accounts than non-ESOP companies do.
Function 2. ESOPs are a way to transfer ownership.
When the current owner of a private company approaches retirement, the company will either need to cease operations or find a new owner. The owner may sell to a family member, the management team, or an outside buyer, but some choose to transfer to their employees via an ESOP. The advantages of an ESOP for these owners include significant federal and, usually, state tax incentives, as well as a flexible structure that allows owners to leave the business on a schedule of their choosing. Owners receive fair market value for their shares, as determined by an independent appraiser. In some cases, the tax incentives mean that the former owners end up with greater after-tax proceeds, although in others they may be able to earn more by selling to someone else.
For most sellers, legacy is at least as important as maximizing the financial value of the sale. They may prefer selling to an ESOP because they worry that outside buyers will have different goals for the company than the original owner. Those buyers may not be willing to ensure the continued employment of the existing workforce, and they may change the values and character of the business.
For more information about employee ownership, explore these selected resources.