Home > Reference Desk > Plan Basics >

How to Choose an Employee Stock Plan for Your Company

WHAT THE DIFFERENT PLANS ARE AND HOW TO START DECIDING WHAT PLAN(S) ARE RIGHT FOR YOU

ESOPs, 401(k) plans, stock options, and ESPPs

Many companies we encounter have a pretty good idea of what kind of employee ownership plan they want to use, usually based on specific needs and goals. However, sometimes they might be better served by another kind of stock plan. And yet others say they'd like to have an employee ownership plan, but they're not sure what it might be. This article will start you down the path to choosing and implementing the plan or plans best suited to your company.

Plans for Broad-Based Employee Ownership

Let us begin by quickly reviewing the main possibilities for broad-based employee ownership. A "broad-based" plan is one in which most or all employees can participate. (Note to non-U.S. readers: like everything else on this site, this is U.S.-specific.)

An employee stock ownership plan (ESOP) is a type of tax-qualified employee benefit plan in which most or all of the assets are invested in stock of the employer. Like profit sharing and 401(k) plans, which are governed by many of the same laws, an ESOP generally must include at least all full-time employees meeting certain age and service requirements. Employees do not actually buy shares in an ESOP. Instead, the company contributes its own shares to the plan, contributes cash to buy its own stock (often from an existing owner), or, most commonly, has the plan borrow money to buy stock, with the company repaying the loan. All of these uses have significant tax benefits for the company, the employees, and the sellers. Employees gradually vest in their accounts and receive their benefits when they leave the company (although there may be distributions prior to that). Over 8 million employees in over 11,000 companies, mostly closely held, participate in ESOPs.
A stock option plan grants employees the right to buy company stock at a specified price during a specified period once the option has vested. So if an employee gets an option on 100 shares at $10 and the stock price goes up to $20, the employee can "exercise" the option and buy those 100 shares at $10 each, sell them on the market for $20 each, and pocket the difference. But if the stock price never rises above the option price, the employee will simply not exercise the option. Stock options can be given to as few or as few employees as you wish. Perhaps 7 to 10 million or more employees in thousands of companies, both public and private, presently hold stock options.
Other forms of individual equity plans: Restricted stock gives employees the right to acquire shares, by gift or purchase at a fair value of discounted value. They can only take possession of the shares, however, once certain restrictions, usually a vesting requirement, are met. Phantom stock pays a future cash or share bonus equal to the value of a certain number of shares. When phantom stock awards are settled in the form of stock, they are called restricted stock units. Stock appreciation rights provide the right to the increase in the value of a designated number of shares, usually paid in cash, but occasionally settled in shares (this is called a "stock-settled SAR"). Stock awards are direct grants of shares to employees. In some cases, these shares are granted only if certain performance conditions (corporate, group, or individual) are met. These awards are usually called performance shares.
An employee stock purchase plan (ESPP) is a little like a stock option plan. It gives employees the chance to buy stock, usually through payroll deductions over a 3- to 27-month "offering period." The price is usually discounted up to 15% from the market price. Frequently, employees can choose to buy stock at a discount from the lower of the price either at the beginning or the end of the ESPP offering period, which can increase the discount still further. As with a stock option, after acquiring the stock the employee can sell it for a quick profit or hold onto it for awhile. Unlike stock options, the discounted price built into most ESPPs means that employees can profit even if the stock price has gone down since the grant date. Companies usually set up ESPPs as tax-qualified "Section 423" plans, which means that almost all full-time employees with 2 years or more of service must be allowed to participate (although in practice, many choose not to). Many millions of employees, almost always in public companies, are in ESPPs.
A Section 401(k) plan is a retirement plan that, unlike an ESOP, is designed to provide the employee with a diversified portfolio of investments. Like an ESOP, however, a 401(k) plan is a tax-qualified plan that generally must include all full-time employees meeting age and service requirements. The employees can choose among several or more choices for investments, and the company may make a matching contribution. Perhaps several million employees in a few thousand companies participate in plans with a heavy company stock component; company stock may be an investment choice for the employees and/or the means by which the company makes matching contributions. 401(k) plans may be combined with ESOPs (these are called "KSOPs"), where the company match is an ESOP contribution.

Remember...

ESOPs Are Not Options

People who are familiar with stock options and encounter the word "ESOP" sometimes think it means "Employee Stock Option Plan," but it means nothing of the sort, as explained above. ESOPs and options are totally different. Neither is "ESOP" a generic term for an employee stock plan; it has a very specific legal definition. (Outside the U.S., "ESOP" means various things, ranging from U.S. ESOP-like plans to stock option plans.)

"Incentive Stock Option" Is Not a Generic Term

Another common misconception is that "incentive stock option" is a general term for stock options given as an incentive to employees, etc. Actually, the incentive stock option is one of two types of compensatory stock options (the other type is the nonqualified stock option), and it has very specific legal requirements.

Typical Situations

Having covered the plans you might use, let us see where they fit into typical corporate situations:

Private (Closely Held) Companies

Companies that plan to go public or be acquired (high-tech startups, etc.): Even after the dot-com bust of 2000, options are still the currency of choice when it comes to attracting and retaining good employees; many high-tech workers won't take a job without options. As the company is going public, it is common to put a stock purchase plan in place as well.
Closely held companies with owners looking to sell some or all of their stock: An ESOP is usually the best choice. In most cases, the ESOP will borrow money to buy out the shares, but the company may just put in cash for several years in a gradual sale. If the company is a C corporation (rather than S), the owner, if certain conditions are met, will be able to avoid paying any taxes on the sale proceeds provided they are rolled over into stocks and bonds of U.S. operating companies. Stock options would not work at all.
Traditional closely held companies that will stay private but do not have a selling owner: If your company is not going to experience a liquidity event (going public or being acquired), then an ESOP or 401(k) plan is probably your best bet for a broad-based plan. With stock options or a stock purchase plan, your company would have to create a market for the stock, which could create costly and cumbersome securities law issues. Options or purchase plans are thus generally used only as management compensation in such companies.
1. If the company simply wants a stock plan that will acquire small amounts of stock to reward employees on an ongoing basis: A non-leveraged ESOP would probably work well. An ESOP will generally cost $20,000 or more to set up, even in a small company; there also will be yearly administrative and valuation costs. If the tax and other benefits of an ESOP do not outweigh these costs, then a 401(k) plan with company stock as the employer match may be best (making the company stock an employer match, not an employee investment choice, avoids securities issues).
2. If the company needs a management-only incentive program, either alone or to supplement a broad-based plan: ESOPs, 401(k) plans, and Section 423 ESPPs must be broad-based and thus won't work for executive-only plans. You can use stock options or nonqualified stock purchase arrangements; generally, the company will have to buy the stock back because there is no market for it. You also can use synthentic equity (phantom stock or SARs, discussed below).

Public Companies

In some ways, public companies have more flexibility when choosing a stock plan, since (1) there is a market for the stock, thus meaning the company doesn't have to buy it back from employees; (2) there are no securities issues since the stock is already registered, and (3) they typcially have larger budgets than private companies, some of which, for example, balk at paying the hefty sums associated with setting up an ESOP. Thus, the selection process has less to do with eliminating the plans that simply won't work well and more to do with weighing their pluses and minuses.

Stock options, and to a lesser extent stock purchase plans, are especially useful when you are hiring the kinds of employees who expect them as a condition of employment. And having employees buy stock through options and purchase plans can be a source of revenue for the company. However, don't forget ESOPs; as a long-term, tax-advantaged plan, the ESOP can help both a company and its employees develop a true ownership culture. And including company stock in a 401(k) plan is a very widespread practice in America's public companies.

In many cases, you will want to have at least two kinds of plans: for example a broad-based stock option plan plus an ESOP, or an executive option plan plus a broad-based Section 423 purchase plan, etc. What you do will depend on the desires and needs of your company and your employees.

Very Small, Private Companies on a Budget

What if your company is very small (maybe 7 or 10 employees), plans to stay that way, and the cost of setting up an ESOP or even a 401(k) plan seems prohibitive? There is no easy answer for you; perhaps a yearly cash bonus based on company performance would be better than a stock plan. You might read our Conceptual Guide to Employee Ownership for Very Small Businesses for more ideas and a general grounding in the issues.

The Lure of Phantom Equity

"Phantom equity" refers to plans such as phantom stock or stock appreciation rights (SARs) that provide employees with a payout, usually in cash, based on the increase in the company's stock value. (Employees may receive stock instead of cash, and phantom stock can include phantom dividends, etc., but the basic idea is a bonus based on the company's stock performance.) Sometimes a company asks about substituting phantom equity for real equity when setting up a broad-based plan; after all, it would seem that by avoiding real stock you could avoid all the messy issues that stock can bring with it.

Alas, life is not that simple. Aside from various practical questions such as valuation, funding, adverse accounting treatment, taxation, and employee motivation that arise when you set up a phantom equity plan, there is a serious legal issue. If you set up a plan, no matter how you characterize it, that acts like a retirement plan by covering most or all employees and deferring some or all payment until termination, it is subject to ERISA (the Employee Retirement Income Security Act of 1974), which means your company could be hit with a host of problems once the government sees what you're doing. To avoid ERISA issues, a phantom stock or SAR plan should be limited to a few key employees and/or have a short payout period, such as one year.

The bottom line, then, is that phantom stock and SARs are best suited for executive plans and, as broad-based plans, are very unlikely to be suitable alternatives to one of the stock plans discussed above.

Where to Go from Here

An article like this can only scratch the surface of a complicated subject. The suggestions made here are only suggestions, and may not fit your particular situation--that's why the heading above reads "Typical Situations." It is essential that you educate yourself further and, if you set up a plan, hire the right people to help you.

Personal Advice and Suggestions

If you are an NCEO member or if you join us, you can call or email with questions or just to have a general discussion. We always suggest that members who are deciding which plan(s) to use consult with our executive director, Corey Rosen. Also, you can hire us to speak to your company or provide introductory consulting.

Hiring Service Providers to Set Up Your Plan

It is crucial not only that you be well informed but also that you hire experienced, qualified, and ethical professionals. NCEO members have access to the members area of this site, where they can read extensive advice on who they need to hire and how to hire them, and then search our database of 200-some service providers.

And Don't Forget...

An employee stock plan may mean very little to employees unless you communicate it well! As you explore what we have to offer, don't miss our resources on communicating plans to employees (such as our publications Communicating Options and The ESOP Communications Sourcebook, plus our meetings on communicating to employees) as well as our ownership culture resources.

^^Top of Page