ESOPs provide ownership and an incentive for employees to increase profits and share price: the benefits flow right back to them when they cash out. In brief, employees are granted company stock for their service. It's another form of non-monetary compensation, and ostensibly part of a retirement plan.
In motivation ESOPs are similar to profit-sharing and variable compensation for encouraging workers to care about the company's performance. ESOPs also bear resemblance to restricted stock units, being a form of equity granted to employees for their service. They're also comparable to co-ops for empowering employee ownership.
Though worker co-ops however are relatively rare compared to ESOPs. The National Center for Employee Ownership reports there to be only 394 worker co-ops in the US, compared to 6,272 companies with an ESOP in 2017/2018.
ESOP arrangements make up a number of big names, including Publix and WinCo. It's worth noting that some companies with ESOPs are wholly employee owned, and some aren't.
All in all, I'd say ESOPs are fairly moderate. They're not particularly radical or exciting, but they are solid at what they do. They also open the doors to the broad world of employee ownership – though you can't force a company to walk through that door and actually adopt good worker-owner practises.
The basics of employee stock ownership plans
First of all, having an ESOP does not make a company anywhere near as radically redesigned as co-ops are in terms of governance. Companies with ESOPs are likely S-corps or C-corps with the usual trappings.
They likely have a board of directors that chooses the direction of the company, and they may have external investors. Those external investors may even own a controlling share of the company, in which case the ESOP is only for compensation and not a matter of employee involvement.
Companies offer ESOPs at no cost because of the numerous tax advantages:
Most notably, S-corps are not subject to federal income tax for the portion of the company owned by the ESOP. So if a company is 100% ESOP owned, then it pays no taxes on its earnings. This is great synergy for companies that have high profits and low debt.
The NCEO has a whole article on ESOPs that further details how it works, and is well worth a read:
To summarise the article, ESOPs are a trust fund set up by the company to benefit employees. Employees are granted stock over time, and when they leave the company they must be cashed out of their stake in the ESOP. There are many tax advantages to it, including the ability to borrow money in a tax deductible way, and that dividends are tax deductible.
It's worth noting that ESOPs are expensive to run. They rely on a number of lawyers, fiduciaries, and (in private companies) valuators to arrange the ESOP. These people come with a price tag, so for small companies the tens of thousands of dollars can be off-putting.
A leveraged ESOP horror story
The NCEO reports that approximately half of all ESOPs are currently leveraged, with two-thirds of all new ESOPs starting out leveraged. Leverage means that a company borrows money for the ESOP.
I invite to your attention the interesting case study of Polaroid's ESOP initial success turned retirement flop:
To summarise, Polaroid defended themselves from a hostile takeover by dumping shares into sympathetic hands via an employee stock ownership plan. They leveraged the ESOP, and the influx of cash presaged a spiral into a borrowing spree.
They made mandatory payroll deductions to fund the ESOP, rightfully pissing off a number of their workers. They also failed to actually value workers as employee-owners. The company then collapsed, becoming a penny stock and wiping out employee stock value.
There's several salient lessons to salvage out of this story. Number one is that worker ownership just means accountability, and doesn't imply control over the company. Risk without the controls, so reward is out of their hands.
For example, the board can still be composed of non-workers. Or the hierarchical worker & manager divide can be in place, effectively shutting down workplace democracy.
Not to mention that being an employee-owner is more difficult than being an employee or an owner alone. You have to juggle two disparate duties fluently – or more likely, you'll struggle to do both adequately. It's asking a lot of every employee to be versed in accounting, business, and management all at once.
It's also a common theme for ESOPs to be an employee benefit that floats alongside a company, neither transforming it nor hindering it appreciably. As I said earlier, ESOPs are moderate. Unless you choose to embrace them wholly, they can fade into the woodwork.
Is it worth focusing your retirement strategy on an ESOP?
I'd say hell no.
We're talking about an undiversified asset that is highly correlated with your employment income stream. It's also often locked up and inaccessible unless you leave the company or something major occurs that allows you to liquidate. To confound matters further when retiring before the "normal" retirement age you can be subject to a 10% income tax penalty. That's a major no-no for early retirement folks.
ESOPs are nice but they're nothing to write home about – sticking to the fundamentals are a more reliable path forward. Live within your means, invest in index funds as much and as early as you can afford, and always strive to improve yourself. Having an ESOP is valuable, but it should not be your prime focus.
That said, there are plenty of wealthy individuals who made themselves through working at the big name ESOP companies, such as the millionaires from WinCo.
Ultimately that's what counts. ESOPs are yet another way to successfully gather enough money to be financially independent – to be able to say "No" – even if they are not the most interesting way of doing so, or the most reliable.