ESOPS: Pros and Cons | AbstractOps

Image credit: Unsplash

TLDR

As part of a compensation and benefits package, startup founders can offer equity — a valuable and desirable asset.
One way to provide startup equity is through an employee stock ownership plan (ESOP).
An ESOP is an employer-sponsored benefit plan governed by federal law, similar to a profit-sharing plan.
For an ESOP, a company establishes a trust to contribute cash to purchase existing shares of stock or new startup shares.
These shares are then assigned to individual accounts for employees eligible to participate in the ESOP, typically based on a percentage of pay or a flat amount determined by the founders.
Startups commonly use ESOPs to “provide a market for the shares of departing owners of successful closely held companies, to motivate and reward employees, or to take advantage of incentives to borrow money for acquiring new assets in pretax dollars.”
Many ESOP tax benefits exist for both the startup and its employees.
When funding an ESOP, founders contribute cash or new stock to the plan up to specific limits, as identified by the Internal Revenue Service. These contributions are generally tax-deductible up to 25 percent of payroll.
Employees pay no tax on any contributions made to an ESOP on their behalf. The contributions in the plan grow — tax-free — until the participant chooses to take a distribution. Startup employees receive favorable tax treatment on distributions as well.
When cash dividends are paid directly to ESOP participants, these dividends are taxable but not subject to the early distribution penalty. Additionally, if the startup pays cash dividends to ESOP participants, then the startup may generally deduct those dividends, as long as the dividend payments are reasonable.
If the startup is sold, the acquiring company may cash out the shares of stock, distribute cash directly to the employees, or roll over the shares' cash equivalents to the acquiring company’s retirement plan.
The founders must at all times — including a sale of the company — act in the best interest of the participants, making sure the deal is fair and reasonable.

One of the most challenging obstacles for startups in today’s competitive market is hiring top talent. Where “[h]eavyweights such as Google and Facebook can lure top talent with six-figure salaries, lucrative stock packages and lavish perks, including sushi buffets and free laundry service,” smaller startups may think they’ll have a hard time competing for the most skilled employees.

To compete in what’s now known as the "Second War for Talent," startups must be creative when hiring and retaining skilled employees. After all, top talent is critical to building and scaling your startup, leveraging the additional skills of those you bring aboard.

As part of a compensation and benefits package, startup founders can offer equity — a valuable and desirable asset. One way to provide startup equity is through an employee stock ownership plan (ESOP), the most popular type of U.S. employee ownership. For a startup, founders offer selected employees, advisors, and consultants a way to participate in the upside of a startup by owning stock at a discounted price while paying them a lower cash salary. Doing so can motivate and reward employees, encouraging them to help grow and scale the startup.

In this article, we’re going to explore the pros and cons of startup ESOPs and how they can benefit your startup.

How ESOPs Work in Startups

Employees can own startup stock in several ways. For example, they can purchase stock straight from the company, the founders can give it to them as a bonus or incentive, or they can own stock through an ESOP. An ESOP is an employer-sponsored benefit plan governed by federal law, similar to a profit-sharing plan.

For an ESOP, a company establishes a trust to contribute cash to purchase existing shares of stock or new startup shares. These shares are then assigned to individual accounts for employees eligible to participate in the ESOP, typically based on a percentage of pay or a flat amount determined by the founders.

To participate in the ESOP, the plan documents will specify specific requirements that employees must meet, such as being a full-time employee, being 21 years of age or older, or working for the startup for at least one year. Once a participant in the plan, the employee will earn a right to these shares of stock through a process called vesting. Under federal law, employees must be fully vested in their startup shares within six years at the latest. The exact number of years is reflected in the ESOP’s plan documents, known as a vesting schedule.

If an employee leaves the startup before satisfying the vesting schedule, then they may forfeit (or lose) part or all of the startup stock. However, suppose the employee satisfies the plan’s vesting schedule, meaning that they were employed with the startup for the length of the vesting schedule. In that case, the employee will receive the cash value for the shares of stock upon leaving.

ESOP Uses

Startups commonly use ESOPs to “provide a market for the shares of departing owners of successful closely held companies, to motivate and reward employees, or to take advantage of incentives to borrow money for acquiring new assets in pretax dollars.”

Let’s look at each of these in turn:

Departing Owners: With an ESOP, departing founders of a startup can take advantage of an immediately available market for their shares, making the transition of ownership easier for both the startup and the departing founders.
Motivate and Reward Employees: A startup creates an “additional employee benefit,” motivating and rewarding employees with ownership by offering an ESOP to employees.
Borrow Money: ESOPs are unique in that founders can borrow money from them, often called “ESOP financing.” This type of financing may be more favorable than traditional financing, from a bank, for example. However, the proceeds of the ESOP loan must be primarily used for the benefit of the employees. These transactions can be complex, and it’s best to work with an attorney familiar with ESOPs if you’d like to explore this option.

ESOP Tax Benefits

Many ESOP tax benefits exist for the startup and its employees. Let’s first look at tax benefits for the startup.

For the Startup

When funding an ESOP, founders contribute cash or new stock to the plan up to specific limits, as identified by the Internal Revenue Service. These contributions are generally tax-deductible up to 25 percent of payroll. However, if the startup has another retirement plan, such as a 401k or profit-sharing plan, the available tax deductibility is aggregated across all plans. In other words, if a startup has an ESOP and a 401k plan, then the startup can generally deduct up to 25 percent of payroll for contributions made to both plans, not made to each.

Additionally, if the startup pays cash dividends to ESOP participants, then the startup may generally deduct those dividends, as long as the dividend payments are reasonable. Further, the dividend deductions are not subject to the 25 percent limitation set forth above.

If your startup is an S-corporation, different rules may apply under the Internal Revenue Code. For example, S-corporation ESOP distributions (otherwise known as dividends for other entities such as C-corporations) are not generally tax-deductible. It’s best to contact an attorney familiar with ESOPs to discuss the intricacies of an S-corporation.

Now, let’s look at the tax benefits an ESOP can offer employees.

For the Employees

Employees pay no tax on any contributions made to an ESOP on their behalf. The contributions in the plan grow tax-free until the participant chooses to take a distribution. Startup employees receive favorable tax treatment on distributions as well.

If an employee chooses to take an ESOP distribution, the employee will be subject to tax depending on the plan terms. If the employee is younger than 59 ½ when they take the distribution, an additional 10 percent tax shall be applied, known as the early distribution penalty. This penalty is in addition to other taxes owed.

Startup employees can also roll their ESOP distribution over into another retirement plan or individual retirement account (IRA), extending (or deferring) the timing of any tax payment on the distribution. However, when cash dividends are paid directly to ESOP participants, these dividends are taxable but not subject to the early distribution penalty. This favorable tax treatment does not apply to dividends payments made by an s-corporation.

When to Start an ESOP for Your Startup

Although there is no specific best time to start an ESOP, you should answer some questions about where you are in your startup journey. Answers to these questions will not only determine if your startup is ready to offer an ESOP as an employee benefit, but it will also lay the foundation for the ESOP itself.

For example, when considering an ESOP, you (and your co-founders) should explore the following questions:

Which employees will participate in the plan?
How will the startup’s employees react to an ESOP plan?
What vesting schedule will apply?
How will the startup make contributions to the ESOP?
Will voting rights extend to participants?
What is the financial status of the startup?
Which professionals will the startup need to engage to manage the ESOP?
What are the costs associated with starting an ESOP?
Do the potential benefits of establishing an ESOP outweigh the costs?

How to Set up an ESOP

For founders ready to offer an ESOP, they must follow several steps in implementing one. First, make sure that all founders and owners are on board. The managerial agreement is critical to a successful ESOP.

Second, hire an experienced attorney to prepare the ESOP plan documents. The plan documents will address employee eligibility, contributions, vesting, distributions, and administration. Once the plan documents are ready, all board members of the startup must approve the plan's adoption through a written resolution. Depending on the business’s organization, the startup may also need shareholder approval.

The startup will then need to offer a grant letter — a formal document offering the ESOP to employees. Your ESOP attorney can help you with the drafting and distribution of this letter.

To determine the cost of the ESOP’s shares, your startup should have an outside, independent valuation. In addition, for privately-owned startups, an annual valuation is required.

ESOP Distribution When Your Startup Is Sold

If you decide to sell your startup, the purchaser may cash out the shares of stock, distribute cash directly to the employees, or roll over the shares' cash equivalents to the acquiring company’s retirement plan.

Federal law requires that the buyer's purchase price must not be less than its fair market value, as determined by the outside, independent valuation of the startup. The founders must at all times — including a sale of the company — act in the best interest of the participants, making sure the deal is fair and reasonable.

The acquisition process is a lengthy one. Because of this, during the sale of the startup, the cash equivalents of the ESOP’s stock may be held in escrow until all acquisition issues are formally resolved.

During the sale of the startup, you must keep in mind that the transaction is not only lengthy but complex, primarily because of the ESOP. During the sale process, your startup will have to invest in significant planning, as it will have to participate in detailed due diligence and secure approvals by the Internal Revenue Service in addition to conducting valuations. Because of this, your startup will want to make sure it receives necessary professional advice so there are no unwanted surprises.

Learn more with us

Access more guides in our Knowledge Base for Startups.

We can help!

At AbstractOps, we help early-stage founders streamline and automate regulatory and legal ops, HR, and finance so you can focus on what matters most—your business.

If you're looking for help with understanding how to hire interns, get in touch with us.

Like our content?

Subscribe to our blog to stay updated on new posts. Our blog covers advice, inspiration, and practical guides for early-stage founders to navigate their startup journeys.

Note: Our content is for general information purposes only. AbstractOps does not provide legal, accounting, or certified expert advice. Consult a lawyer, CPA, or other professional for such services.