ARTICLE
September 2020

Start Here: For Business Owners

How Employee Ownership Works

More than 12,000 U.S. companies share ownership broadly with over 25 million employees.

Companies choose to share ownership widely for a few key reasons:

  • The most common form of employee ownership, an employee stock ownership plan (ESOP), is the most tax-effective way to provide for business transition in closely held companies.
  • Sharing ownership with employees in ongoing businesses can be a very powerful way to increase employee engagement while attracting and retaining talented people at all levels.
  • Employee ownership may be philosophically aligned with basic notions of economic fairness.

The two main ways to share ownership are ESOPs and equity compensation. Links in the article direct you to more details about each approach. If you are not sure what makes sense for you, please contact us so we can direct you to the resources best for your situation.

Using an Employee Stock Ownership Plan (ESOP) for Business Transition

Congress intentionally created ESOPs as the most-tax effective way to do ownership transition in closely held companies. Not surprisingly, this is the most common reason for employee ownership. An ESOP is a kind of retirement plan, related to 401(k) and profit-sharing plans. The company creates an ESOP trust and makes tax-deductible contributions to it that are allocated to all employees meeting a basic service requirement based on an equitable formula. Employees can sell shares back some time after they leave the company

ESOPs are a way for a company to redeem its own shares using tax-deductible corporate profits. There is no other way to do that. Employees do not buy the shares—the company makes contributions to a special employee trust to buy the shares. The trust then allocates the shares to the employees, who can sell them back after they leave the company. In addition to this core benefit, ESOPs can:

  • Allow sellers to defer tax on the gain that they make by reinvesting in other companies. ESOPs allow a seller to sell all or part of the company.
  • Provide a fair price for the shares.
  • Protect the legacy and culture of the company, allowing owners to exit at their own pace, retaining whatever role they choose.
  • Provide a robust retirement benefit to your employees at no cost to them, one that is linked to company performance.
  • Provide a substantial tax benefit: many companies end up being 100% ESOP-owned, which means they can, if properly structured, be exempt from all income tax.

There are more than 6,000 privately held ESOPs in the U.S., found in every state and industry, from companies with 15–20 employees to thousands of employees. ESOPs have been remarkably successful, outperforming their competitors and generating impressive returns for employees.

“The ESOP concept is so mutually beneficial. I feel fulfilled knowing that I’m doing something my employees will benefit from, and I can liquidate my life’s work at the same time!”

Steve Sain, Sain Engineering Associates

To learn more about how to use ESOPs for business transition, see this article. For a step-by-step guide, get our book Selling to an ESOP.

Other Uses for an ESOP

Where owners are not looking to sell, ESOPs are used as a tax-favored wealth building plan for employees; a way to reward people for their hard work; and to engage, attract and motivate employees. Companies doing this typically issue shares to the ESOP trust, diluting exiting ownership, but generating a tax deduction.

For more details on how ESOPs work overall, see this article. For a comprehensive look, order our book Understanding ESOPs.

Is an ESOP Right for Your Business?

Start exploring an ESOP sale by signing up for an NCEO membership. As a member, we can connect you with an ESOP company in your state or industry, allowing you to learn from its first-hand experience. Members also receive unlimited access to our live and replay webinars, ready-to-use documents, current and past newsletter issues, our ESOP Q&A with more than 700 questions and answers, discounted pricing, research report summaries, and other exclusive content, and they can call or email us for advice. 

Sharing Ownership Using Equity Compensation

Many entrepreneurial companies contact us looking for a way to reward some or all employees with some form of equity grant. Companies of all sizes, from the Fortune 100 to small LLCs, use stock-based compensation to attract and retain employees, and to align the workforce behind the company’s goals. Equity compensation takes many forms, such as stock options, stock appreciation rights, restricted stock, restricted stock units, performance shares, and stock purchase plans. 

These plans allow companies to grant either actual shares or the rights to the economic value of shares. They do not carry the tax benefits of an ESOP, but they can be designed with almost any rules the company chooses, within some limits. Owners can decide who will get how much equity, what the vesting rules will be, how often equity will be granted, and other key issues.

In companies traded on stock exchanges, employee stock purchase plans (ESPPs) are very common. These plans generally allow employees to buy shares at a discount.

Picking a plan that fits your company requires looking at the various options. We can help you navigate this.

For more details, see the article Stock Options, Restricted Stock, Phantom Stock, Stock Appreciation Rights (SARs), and Employee Stock Purchase Plans.

For a detailed look, we have a number of useful publications. Most notably:

The Decision-Maker's Guide to Equity Compensation

Equity Compensation for Limited Liability Corporations

Other Forms of Employee Ownership

There are other ways of providing equity to employees besides ESOPs. 

Worker Cooperatives: Worker cooperatives provide a flexible, easy-to-implement path to employee ownership for companies that want to operate with broad-based democratic governance. Learn more about worker cooperatives from our friends at the Democracy at Work Institute.

Perpetual Trusts: This form of employee ownership is a mainstay in the United Kingdom and has recently emerged in the U.S. It allows a company to set up a trust intended to be a perpetual owner of the company, with employees being the beneficiary of the trust. They do not actually get shares; instead they get a share of annual profits.

Contact Us

Selling your business is a weighty decision with many considerations that are specific to you and your situation. If you have questions about your next steps on employee ownership plans, email us at customerservice@nceo.org or call us at 510-208-1300.