What is an ESOP?
January 13, 2007
I often get questions from my wife, relatives, and friends about my profession. When I start talking about ESOPs, it quickly becomes apparent that they, as well as most people that do not work in the profession or participate in an ESOP, do not even know what an ESOP is. So, what is the best way to quickly explain the definition of an ESOP to someone without a financial background?
The acronym ESOP stands for employee stock ownership plan. Merriam-Webster's online dictionary defines an ESOP as “a program by which a corporation's employees acquire its stock”. While that is a good start, I think more information is needed.
Motley Fool has a page dedicated to many retirement plan definitions, including ESOPs and other terms mentioned below. Here is their definition of an ESOP:
An ESOP is a qualified defined contribution plan in which the assets are invested mostly in qualifying employer stock. Usually, purchases of this stock are funded by employer contributions made to the plan based on total employee compensation. The plan may permit purchase of stock by employees as a plan option. When combined with a 401(k) plan, an ESOP is sometimes called a KSOP. On leaving the firm through separation or retirement, the participant will receive all vested interests in the form of the actual shares in the account. Alternatively, he or she may demand a cash distribution in lieu of the shares.
While I agree with the definition, I think it is too wordy for a simple definition. Here is my simple definition of an ESOP:
An employee stock ownership plan (ESOP) is a type of qualified retirement plan that buys, holds, and sells company stock for the benefit of the employees, providing them with an ownership stake in the company.
The one term that you may be asked about is qualified retirement plan. Most people participate in or are familiar with a 401(k) Plan. A 401(k) Plan is a good example of a qualified retirement plan that most people are familiar with.
Let’s compare my definition to the definitions provided by the leading employee ownership organizations:
The National Center for Employee Ownership (NCEO)
An employee stock ownership plan (ESOP) is a type of defined contribution benefit plan in the U.S. that buys and holds company stock. ESOPs are often used in closely held companies to buy part or all of the shares of existing owners, but they also are used in public companies. Related to ESOPs are Section 401(k) plans, which may be used alone or in conjunction with ESOPs to hold company stock. Note: ESOPs have nothing to do with stock options
This first sentence of this definition is very similar to mine. In fact, at one point I had the defined contribution plan in my definition, but ultimately removed it to simplify the definition for those without a financial background. I also liked the note that ESOPs have nothing to do with stock options, as people often think of ESOPs as employee stock option plans instead of employee stock ownership plans.
The ESOP Association
An Employee Stock Ownership Plan (ESOP) is an employee benefit plan which makes the employees of a company owners of stock in that company. Several features make ESOPs unique as compared to other employee benefit plans. First, only an ESOP is required by law to invest primarily in the securities of the sponsoring employer. Second, an ESOP is unique among qualified employee benefit plans in its ability to borrow money. As a result, "leveraged ESOPs" may be used as a technique of corporate finance.
One thing that separates this definition from all of the other definitions we looked at is the ownership component.
How have you quickly explained ESOPs to someone without a financial background?