WHAT IS AN ESOP?
Chapter 1 from ESOPs in Canada: How to Implement an Employee Share Ownership Plan to Grow and Exit your Business with your Legacy Intact
by: Perry Phillips and Camille Jensen
“Giving all workers a greater stake in the company they work for is a powerful way of aligning the interests of employees with that of the business. A worker who has a financial and personal stake in a company will take more responsibility for its success.” – Norman Lamb, former U.K. Minister for Employment Relations
In technical terms, an ESOP is a formal stock equity plan that can include stock equity, stock options, or phantom stock (definitions for these terms provided further below).
An ESOP can be part of an employee benefits package or a corporate financing strategy.
The plan can be open to key personnel or all employees, enabling them to purchase in total from 1 per cent to 100 per cent ownership in the company with the securities acquired through cash payment, profit sharing, bonuses, or services rendered. The equity ownership allows qualifying employees to participate in and benefit from the growth of the company in return for a commitment to stay for the long haul.
ESOPs allow employee-owners to share in the company’s success through increased share value that can be sheltered for tax-free gain. Favourable tax treatment is available because these gains can be classified not as income earned, but as a capital gain, which is taxed at a much lower rate than income.
That is the technical description.
In fact, ESOPs defy easy explanation; every plan is unique. The plan’s purpose, participation, and parameters are flexible and tailored to the individual company. In general, though, there are certain common results. When coupled with a corporate philosophy of participative management, ESOPs create an ownership mentality. Employees think and act like owners because they actually are owners. Workplace dynamics shift from a “working for” to a “working with” mentality. The outcomes are improved motivation, communication, productivity, and profitability.
THE THREE TYPES OF ESOP
ESOPs are built with three basic tools: stock equity, stock options, or phantom stock units. A plan may comprise only one, a combination of any two, or all three tools.
Stock equity is the legal transfer of ownership of a share of stock issued by a company. An employee who owns this share has ownership that may or may not have additional rights attached to it. For example, the share may allow the employee to vote at the annual shareholders’ meeting, or the share may be non-voting.
Stock equity has the greatest potential for creating an ownership mentality within the company because the employee generally has to pay for the stock. This payment requires the employee to take an investment risk in the company. It is this risk potential that puts the original owners and the new employee owners on the same level.
Stock options constitute a contract between the company and the employee to sell equity to the employee at some point in the future, at a price calculated in the present day. At that future date, if the company has increased in value, the employee will be able to purchase company stock at a significant discount and have a real gain in wealth. If the share value declines, the employee does not lose anything because he or she simply does not exercise the option to buy the stock. A stock option can be a motivator and a surrogate for ownership.
However, it may not be effective as equity ownership.
Phantom stock units mirror real stock equity with equivalent rights except the right to vote. There is, however, no legal transfer of ownership, and this tends to be the greatest drawback of phantom stock. It does not create the conditions necessary for true ownership because the employee does not have legal title to any of the assets of the company. However, by adding equity conversion rights to these units, phantom stock can approach true equity plans. The equity conversion allows the phantom units to be converted to real stock equity upon a
For example, five years from the time that the phantom plan is put into place, an outside purchaser may buy shares of the company. Employees with the phantom stock units can transfer their units into real shares of the company prior to the closing of the acquisition, sell those shares to the acquirer, and realize a substantial gain in equity. Phantom stock units are used when the ownership group is not comfortable with transferring real equity ownership to the employees and does not want employees to have a vote.
The term “phantom plans” is used by practitioners in the field but not when presenting to employees, because the term tends to indicate something false. To avoid this problem, many phantom plans are known as either participation or value-added plans.
At ESOP Builders, we use the term Equity Value Ownership Plan (EVOP™).
THE IMPORTANCE OF EQUITY TYPES
Stock equity, stock options, and phantom stock may be viewed as a continuum, with stock plans being on the extreme left, stock options in the middle, and phantom plans on the extreme right.
The left portion of this continuum represents the maximum changed mindset with regards to employee ownership mentality. In other words, when employees actually own shares in a company, they believe that they are owners, and the process of participation is easier to implement.
In the middle of the continuum, stock options are less effective in creating an ownership mentality due to the fact that the employee does not actually own anything. He or she merely has the right to future ownership. This right can still be a powerful force in creating an ownership mentality, but it is not as strong as pure equity ownership.
On the extreme right of the continuum are phantom plans. These have limited ability to create an ownership mentality as there is no ownership nor is there likely to be. However, with certain conditions attached to these plans, some ownership mentality can be created. In fact, these plans are still better than no plan at all. In many cases a phantom plan can be a precursor to a share equity or option plan at some future date.
Why do some companies use only one type of plan while others mix and match the elements? The answer lies in the culture of the company and the mindset of the current ownership group.
A culture of open sharing of information, for example, will likely go for an equity and/or option plan, while a culture that is secretive will probably favour the phantom plan.
There is no right or wrong approach to this design issue. Each plan must meet the criteria as set by both the culture and ownership group’s comfort level in terms of sharing ownership. The key to a successful plan is proper identification of the culture and ownership type at the beginning of the assignment so as to create a match.
Another aspect that can come into play in choosing the plan type is whether or not the company can legally offer equity and/or option plans. For example, accounting and legal firms may not be able to issue shares and thus have to look at a phantom plan augmented by some participative designs to achieve a successful ESOP.
The first step is to determine your company’s culture.
For example, if your company tends to give out quarterly financial information, has training programs that encourage employees to understand financial statements, and is open with the communication of these issues, the most effective plan for your company would be a stock equity and/or a stock option plan.
If your company is concerned with attracting and keeping your key people only, you may want to look at a pure stock option plan.
If your company tends to not communicate its financial positions, does not have a profit sharing plan, and makes decisions from the top down and not the bottom up, you should probably consider some type of phantom plan to start with.
ESOPs represent a win-win, where an employee is motivated to see that the company is a success for everyone in that company.
ESOPs are flexible and may be used in many situations for a variety of purposes. Because of
their adaptability, no two ESOPs are the same, and each ESOP may be planned and custom fit to a particular culture and type of company. Whether the company is looking at an ESOP for attraction or retention purposes, or for purposes of succession planning, or for higher productivity and value for the current business owners, it is important to assess whether the company is in fact a good candidate for an ESOP.
Because of the expense and the implications of addressing ESOPs and introducing them to an employee group, it is critical that the ownership group determine this as soon as possible.
Copyright © 2015 by Perry Phillips and Camille Jensen
WHAT IS AN ESOP?