ESOPs or Stock Options: Which Will Work for Your Company?

ESOPs or Stock Options: Which Will Work for Your Company? 

by Corey Rosen

ESOPs: The Basics

An employee stock ownership plan is a kind of qualified employee benefit plan, meaning it qualifiesfor tax benefits if you abide by certain rules. A company sets up a trust fund for employees. The company then contributes cash to the trust so that it can buy company shares or just contributes shares. Alternatively, the trust can borrow money to buy shares, with the company repaying the loan by making contributions to the trust. Within limits, company contributions to the trust are tax deductible.

Once shares are in the trust, they are allocated to accounts of at least all full-time employees (with some limited exceptions). They are then subject to vesting, and employees receive their shares when they leave the company. At that point, they can sell them back to the company or on the market, if there is one.

Closely held companies must have their share price set by an annual outside appraisal. Employees own the shares through the trust, but closely held companies can control the voting of the trust on almost all issues if they so choose.

Stock Options: The Basics

Stock options allow employees to purchase shares in their company at a price fixed when the optionis granted (the grant price) for a defined number of years into the future. Option rights are usually subject tovesting.

For instance, a company may give an employee the right to buy 100 shares at the current price of $10 per share in 1998. The employee vests in this right over four years at 25% per year, meaning after the first year, options on 25 shares could be exercised. There is a time limit on the exercise, typically 10 years from the date of grant.

There are two main kinds of options, incentive stock options (ISOs) and nonqualified stock options(NSOs). With an ISO, if certain rules are met, the employee does not have to pay tax on the “spread”between the grant and exercise price until the shares are sold. Capital gain taxes would then be due. The company, however, cannot take a tax deduction for the spread. With an NSO, the employee pays taxes on the spread just as if it were wages, and the company can take a corresponding tax deduction.

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The Reasons

1. You Want to Sell Some of Your Ownership

  • An ESOP allows owners of closely held companies to sell to an ESOP and reinvest the proceeds from the sale on a tax-deferred basis, provided that the ESOP owns at least 30% of the company and certain other rules are met. The company can use tax-deductible dollars to make the purchase.
  • Stock options do not work for this purpose. Employees are buying either new shares of stock issued by the company or existing shares at a bargain price. If they are buying existing shares, the price would rarely be acceptable to the seller.

2. You Want Employees to Invest in the Company

  • It is very rarely practical for ESOPs to allow employees to purchase shares through the plan.
  • The exercise of an option brings cash into the company if new shares are bought, but the shares are bought at a discount.

3. You Want to Finance Growth

  • An ESOP can borrow money to buy newly issued shares. The company uses these funds to buy other companies, buy new equipment, or any other corporate purpose. The company repays the loan in pretax dollars by making contributions to the ESOP.
  • Stock options bring an infusion of cash when employees exercise their options, but only if theemployees are buying newly issued shares. That, however, dilutes other owners. Many companies buy back existing shares equal to the number of options exercised, bringing in no new capital.

4. You Want to Motivate Employees

  • There is considerable research linking employee ownership to substantially improved corporateperformance, provided that companies make financially significant contributions to the ESOP (at least 5% of pay per year), share corporate performance information, and get employees involved in decisions at the work level.
  • There is not any research on how employees react to options, although there is a great deal of anecdotalevidence that options do motivate people. There is good theoretical reason to think that options wouldhave the same effect as ESOPs, but there is no hard evidence yet.

5. You Want to Attract and Retain Selected Employees

  • An ESOP does not allow for discretion in who gets how much ownership. Allocation of shares must be by relative pay or some more level formula. It cannot be based on individual merit.
  • Options allow you to provide however much ownership you want to whomever you want. Inmany industries, offering options has become a prerequisite to getting good people, or sometimes any people.

6. You Want a Simple, Inexpensive Plan

  • ESOPs will generally cost $25,000 and up to install and at least $15,000 per year to run. These costs are almost always a fraction of the tax benefits that ESOPs provide, but this is not always the case. ESOPs arealso more administratively complex than other kinds of ownership plans, requiring outside professionals.
  • Option plans are relatively simple and inexpensive to install. If the company is closely held, however,some way has to be created to determine a price for the share (the largest ongoing cost of an ESOP in aclosely held company is this annual appraisal), although that may be done simply by the board. If thecompany is closely held, the exercise of the options may require compliance with costly securities laws.