401(k) Plans as an Alternative to ESOPs in Small Companies

We received a letter from a company that wanted to include employees in ownership, but was reluctant to set up an ESOP because of its cost and complexity. It also wanted to keep its 401(k) plan. For companies that already have a 401(k), or plan to set one up, a simple solution is to match employee contributions in employer stock. The company could just issue new shares to the 401(k) or contribute cash to buy existing shares.

The disadvantages of this approach are that you will need to have your stock appraised annually, you will dilute ownership for existing owners unless you use company cash to buy shares, and the sale of shares to the 401(k) (if that is how you finance the match) are not subject to the tax-deferral provisions available in a sale to an ESOP (in an ESOP, sellers can defer capital gains taxes if the ESOP that buys their shares ends up with 30% or more of the company's stock after the transaction).

The 401(k) approach also means that share allocation will be based on how much employees choose to save. If a company wants a broader allocation, it could agree to contribute at least a certain amount to everyone, then match on top of that.