Frequently Asked Questions

Employee Ownership FAQs

Common questions about employee stock ownership plans (ESOPs), employee ownership trusts (EOTs), and other forms of employee ownership, from the basics to technical topics.

This FAQ is written primarily for business owners, managers, and advisors involved in setting up or running an employee ownership plan. If you're an employee at an ESOP company looking to understand your own benefits and rights, see our articles on Working at an ESOP Company and The Rights of ESOP Participants.

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What are the pros and cons of a company using its own cash to finance an ESOP (self-financing)?

A company can lend the money to an ESOP itself, assuming it has the cash. The transaction must be an "arm's-length equivalent," meaning it is not less favorable to the ESOP than a conventional loan would be. This is just an accounting procedure in an ESOP, however. The company would loan the cash to the ESOP, the ESOP would use it to buy shares, and the company would repay the money, interest and principal. So the company is getting back the interest and principal on the loan while the ESOP is getting the shares.

Self-financing makes sense if the company does not have an alternative use for the money that would generate a better after-tax return than the company would pay for an ESOP loan. For instance, if the company could borrow at 8%, and is in a 34% tax bracket, its after-tax cost of borrowing is 5.28% (8% minus the tax rate times the borrowing rate, or 8% x 34%). That assumes it pays taxes; 100% S owned ESOPs do not, so their after-tax borrowing cost is still 8%. If the company can use the cash on hand to generate a better after-tax return than that, it makes sense to borrow the money from a lender.

Some companies may also want to avoid the hassles and expense of obtaining a bank loan, or may not be comfortable they can get one. Some bank loans may also impose covenants the company would rather avoid. For instance, some bank loans may prohibit the payment of dividends to shareholders (other than dividends paid to the ESOP to repay the loan) until the loan is repaid.

While corporate cash is sometimes used to fund part or all of a transaction with one or more owners, it is also sometimes used to finance repurchase obligations. When employees leave the company, the company has to buy back their shares. Mature ESOPs (ones who have paid off the acquisition loan) sometimes loan money to the ESOP to make the purchase. Because the loan is paid off over time, the shares from the repurchase are also allocated over time, spreading out the benefit. This can be a useful approach in companies that have a large value of shares outstanding from former employees.

For details on releveraging, see The ESOP Repurchase Obligation Handbook.

Link to this FAQ Topic: Financing an ESOP