Employee Stock Ownership Plan (ESOP) and Employee Stock Options: A Comprehensive Guide

An Employee Stock Ownership Plan (ESOP) is a qualified retirement plan that provides employees with ownership interest in the company. In the simplest terms, an ESOP is a retirement plan. But, in reality, it is much more than that: ESOPs motivate employees, increase productivity, improve worker retention, keep jobs local, contribute to business longevity, and so much more.

Companies might consider establishing an ESOP as a way to transition ownership, reward employees and preserve the company's culture. ESOPs can also serve as an effective employee retention tool, fostering a deeper connection between employees and the company.

As of 2025, the National Center for Employee Ownership (NCEO) estimates there are 6,548 employee stock ownership plans (ESOPs) at 6,358 companies, covering 14.9 million participants and holding over $1.8 trillion in assets. Since the beginning of the 21st century there has been a decline in the number of plans but an increase in the number of participants.

Researchers at Rutgers University estimated that as of 2021 data, 11 million employees participate in equity compensation plans such as restricted stock, stock options, and employee stock purchase plans (ESPPs); in addition, approximately 10,000 are employed in worker cooperatives, while others are beneficiaries of employee ownership trusts (EOTs).

How ESOPs Work

ESOPs are structured as fiduciary trusts that hold company shares for employees. Companies set up a trust fund for employees and contribute either cash to buy company stock, contribute shares directly to the plan, or have the plan borrow money to buy shares. If the plan borrows money, the company makes contributions to the plan to enable it to repay the loan. The trust can be funded through loans taken out by the ESOP, cash contributions from the company or direct contributions of stock by existing shareholders.

Over time, employees receive shares, often based on factors like tenure or salary. Contributions to the plan are tax-deductible. Employees pay no tax on the contributions until they receive the stock when they leave or retire. They then either sell it on the market or back to the company.

About two-thirds of ESOPs are used to provide a market for the shares of a departing owner of a profitable, closely held company. Most of the remainder are used either as a supplemental employee benefit plan or as a means to borrow money in a tax-favored manner. Less than 10% of plans are in public companies.

ESOPs are used across a broad representation of industries, from architects to supermarkets to manufacturers. The most popular sector groups for private companies are professional, scientific, and technical services; manufacturing; and construction. For public companies, they are manufacturing, finance and insurance, and utilities.

Benefits for Business Owners

For business owners, selling to an ESOP offers several tax benefits. Provided that an ESOP owns 30% or more of company stock and the company is a C corporation, owners of a private firm selling to an ESOP can defer taxation on their gains by reinvesting in securities of other companies. Selling to a third party, by contrast, would generally trigger immediate capital gains tax. S corporations can have ESOPs as well. Earnings attributable to the ESOP's ownership share in S corporations are not taxable.

ESOPs also create an internal market for company shares, which can be advantageous for owners who face limited external buying interest.

Benefits for Employees

For employees, ESOPs offer a valuable retirement savings vehicle. As employees accumulate shares in the company, the value of their ownership stake can increase with the company’s success, creating substantial wealth over time. Additionally, the tax-deferred growth of their ESOP accounts means they won’t pay taxes until they begin receiving distributions, which can often be rolled into an IRA.

Employees should note that distributions from an ESOP generally happen after you quit, retire or die. Beyond financial benefits, ESOPs foster a culture of ownership, where employees feel directly invested in the company's performance. This sense of ownership can lead to improved job satisfaction, productivity and loyalty.

According to a 2010 NCEO analysis of ESOP company government filings in 2008, the average ESOP participant receives about $4,443 per year in company contributions to the ESOP and has an account balance of $55,836. People in the plan for many years would have much larger balances. In addition, 56% of the ESOP companies have at least one additional employee retirement plan.

In contrast, only about 44% of all companies otherwise comparable to ESOPs have any retirement plan, and many of these are funded entirely by employees. Participants in ESOPs do well. Employees can also choose to invest in employer stock.

ESOP Fast Facts

• ESOPs boost employee engagement. When ESOPs are formed, shares of company stock are allocated to all employees, making them employee owners who share in the rewards if the stock rises and the risks if the stock falls.
• Most ESOPs require no out-of-pocket contribution from employees.
• ESOPs help narrow the wealth inequality gap. Employees at ESOP companies tend to earn higher wages and have greater savings than their peers in non-ESOP companies.
• In 2018, ESOPs distributed $126.7 Billion nationally.

The Broader Impact of ESOPs

ESOPs provide unique benefits to the employee owners, the institutions, and the surrounding communities that they are involved with. ESOPs have been proven to:

• Motivate employees
• Increase productivity
• Improve employee retention
• Excel at providing employee training
• Keep jobs local
• Counter wealth inequality
• Contribute to business health and longevity

A 2000 Rutgers study found that ESOP companies grow 2.3% to 2.4% faster after setting up their ESOP than would have been expected without it. Companies that combine employee ownership with employee workplace participation programs show even more substantial gains in performance. A 1986 NCEO study found that employee ownership firms that practice participative management grow 8% to 11% per year faster with their ownership plans than they would have without them.

Note, however, that participation plans alone have little impact on company performance.

The global advisory firm Stout released the first annual Stout ESOP Index, which benchmarks the equity prices of about 350 Stout clients against major public market indices. The study found that for the four years ending in December 31, 2024, these ESOP companies delivered 17.3% average annual returns, compared to 3.1% for the Russell 2000 index and 11.9% for the S&P 500.

ESOPs can be found in all kinds of sizes of companies. Some of the more notable majority employee-owned companies are Publix Super Markets (260,000 employees), WinCo Foods (20,000 employees), W.L. Gore and Associates (maker of Gore-Tex, 8,772 employees), and Davey Tree Expert (12,413 employees) (see our Employee Ownership 100 list).

Who Benefits Most From ESOPs?

Communities: Retain a company-including its jobs, products, services, and economic contributions. Get a company that is more likely to stay in business through tough times. Get a company that is more likely to retain employees.

Selling Shareholders: May be able to delay or even eliminate capital gains taxes incurred from selling stock to an ESOP. Can exit the company on their timeline. Can find a willing, qualified buyer when these may be scarce. Can keep alive the culture and company they founded or developed.

Employee Owners: Get a retirement plan that typically requires no out-of-pocket contribution from them. Share in the rewards when the company performs well. Enjoy greater job stability. Often have access to two retirement plans. Are 1.4 times more likely to receive employer sponsored training than employees in non-ESOP companies.

Companies: May be able to avoid paying federal and even state income tax on the portion of the business owned by the ESOP. May be able to take a tax deduction on dividends paid on ESOP stock. Can use an ESOP for tax beneficial financing. Can enjoy business continuity.

Challenges and Considerations

Setting up and maintaining an ESOP is complex and requires significant administrative oversight. As an ERISA-qualified retirement plan, ESOPs must adhere to stringent compliance standards. A critical obligation for ESOPs is the "put option" under IRS Section 409(h), which mandates that companies repurchase shares when participants exit the plan.

This requirement can strain a company’s liquidity, especially if financial conditions deteriorate. Relatedly, annual valuations are required to determine the fair market value of the shares, impacting both sellers of shares to the ESOP and employees from which shares are repurchased when they exit the plan.

Employee Stock Options

Employee stock options are a common equity compensation type granted by companies in the ongoing battle to help recruit, retain and motivate employees. Employee stock options are an equity award that gives the holder the opportunity to exercise (i.e. purchase) the company’s stock at a pre-set price. That pre-set price is called the exercise price or strike price. Whenever the stock’s market value is greater than the exercise price, the option is said to be ‘in the money’. Conversely, if the market value is less than the exercise price, it is called ‘underwater’.

There are two key types of employee stock options: incentive stock options (ISOs) and nonqualified stock options (NSOs).

• ISOs can be given to employees only. They offer the holder a more favorable tax treatment if the shares are held for a specified period but are subject to alternative minimum tax (AMT) which can be a complex tax event. ISOs also come with more restrictions than NSOs, like a $100,000 grant limit and exercise price limit.
• NSOs can be given to non-employees, like contract staff, directors and vendors.

No matter which type of options it is, there are typically four stages in the life cycle of employee stock options: Grant-> Vesting-> Exercise-> Sale.

1. Grant: Employee stock options are awarded at an exercise price.
2. Vesting: Vesting is a waiting period to earn the right to exercise the options. It can be a time-based or performance-based process.
3. Exercise: Once the vesting period has passed, stock options can be exercised at the exercise price.
4. Sale: Stocks can be sold right after exercising.

At grant, employee stock options are awarded at an exercise price. Once the vesting period has passed, stock options can be exercised at the exercise price. For employers, employee stock options can improve employee morale and motivation, increase staff retention and encourage employees to think like owners.

Here are some key considerations when setting up employee stock options:

• Type of employee stock options: Will you be granting incentive stock options (ISOs) or non-qualified stock options (NSOs)?
• Number of stock options to be offered: This number is important as it will determine your company’s total compensation package. Your employees also need this to figure out how much they have to pay if they want to exercise their options. [Total exercise price = No. of options x Exercise price($)].
• Exercise price or strike price: Every employee stock option has an exercise price which is the price at which a share can be bought at an exercise date.
• Vesting schedule: Vesting is a process of earning the ownership of your equity. A common vesting schedule for stock options is 4-year vesting schedule with a 1-year cliff.
• Vesting commencement date: Linked to the vesting schedule.
• Methods to exercise options: Some common methods include monetary payment, sell some to cover and, exercise and sell all. Some companies allow for early exercise.
• Expiration date: Employee stock options often expire 10 years from when they’re issued if they are not exercised. You will need to determine this in your plan rules.
• Time allowed to exercise upon termination: If an employee leaves the company they will typically have a window of 90 days to exercise their options. If they don’t do so within the timeframe, the options will typically expire.

Employee stock options can be a helpful way to make your company thrive. With an ownership-focused mindset, they can help improve staff’s happiness and incentivize them to work harder.

Benefits of Employee Stock Options

Compared to cash bonuses, equity-based awards, such as stock options can potentially provide employees with benefits higher than cash-based awards if the company is a success, i.e. the amount the employee gets is based on the company’s stock price and/or performance over time. This explains why some companies have created millionaires from stock options.

Incentive stock options (ISOs) are tax-efficient employee stock options. If they hold on to their shares for set time they may only owe long-term capital gains at sale.

Here are some of the key benefits of stock options for employees:

• Stock options give employees an opportunity to have ownership in the company.
• The better the company does, the greater the rewards.
• Issuing stock options tends to result in improved staff retention because most employee stock options vest over a number of years.

This vesting period gives the participants a greater incentive to stay with the company for longer. If they leave early, then they won’t receive the full value of their award. Options will become worthless if the stock value of the company doesn’t grow.

It is also possible to dilute other shareholders’ equity when option-holders exercise their stock options.

Summary of ESOPs and Employee Stock Options

ESOPs offer distinctive benefits to both business owners and employees by facilitating ownership transitions, enhancing retirement savings and fostering an engaged, ownership-driven workforce. However, businesses should carefully consider the financial and administrative responsibilities that come with establishing an ESOP, as these obligations may require substantial upfront costs and ongoing commitment.

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