Alphabet Soup – The ABCs of ESOPs

If you have been reading my blog for the past few weeks you may have noted that I have spent quite a bit of time talking about the benefits of an ESOP.  This post is going to look at how an ESOP is formed.

ESOPs are unique.  Each is designed around the needs of the seller, the company, and the employees.  There are some commonalities however.  Let’s look at a simple leveraged ESOP transaction (a leveraged transaction is one where external financing is obtained).

They say a picture is worth a thousand words.  The following graphic can help explain the workings of the ESOP transaction.

Chart explaining ESOPS

The initial transaction:

  • Company establishes the ESOP (a retirement plan)
  • Company borrows money from the bank
  • Company loans money to the ESOP
  • ESOP uses funds to purchase stock from the shareholder(s)

Ongoing contributions:

  • Company makes annual cash contributions to the ESOP
  • ESOP repays company loan
  • Company repays bank loan
  • Unencumbered shares are allocated to participants

Details are important.  You can find out more by reading the article I wrote. Click here to check it out.

Your turn…tell me what you think in the comments section below. I read and respond to every comment!

In addition to blogging here, I also tweet regularly about topics of interest to ESOPs @jlripperger.

Click here to follow my ESOP blog

No investment strategy, such as asset allocation or diversification, can guarantee a profit or protect against loss in periods of declining values. Company stock is not a pooled investment. Stock may experience greater volatility and should not be directly compared to investment options that have a more diversified investment mix. It is not intended to serve as a complete investment program by itself.

 Insurance products and plan administrative services are provided by Principal Life Insurance Company a member of the Principal Financial Group® (The Principal®), Des Moines, IA 50392.   t1210310216

Disclosure Affiliations

t1210310216

  • http://www.principal.com raymond

    ESOP uses funds to purchase stock from the shareholder(s)? In this context, the “shareholders’ are not necessarily the employees (participants), right? My understanding is that employees (participants) purchase “ESOP stocks”, so I really see ESOP as a company/fund, and then ESOP invests their money strategically. (just like how people invest in mutual fund and get profits from it). So in conclusion, the shareholders are whoever purchases the ESOP stocks?

    Jerry, please correct me if I’m wrong. Thanks!

    • Jerry Ripperger, Director-Consulting, the Principal Financial Group, Princor Registered Representative

      An example may help to illustrate the operation of the plan. For simplicity, let’s assume we have a single owner of the stock of a company (Bob). Bob wants to generate some cash, so the company establishes an ESOP and using the proceeds of the loan from the company, the ESOP purchases shares from Bob. Subsequently, the company makes annual contributions to the ESOP which the ESOP then in turn uses to repay the loan to the company. As that loan is repaid, shares are unencumbered and are allocated to participant accounts. These shares are owned by the ESOP (a qualified retirement plan) on behalf of the participants. As a result, employees have a beneficial ownership in the company that they work for.

      • Anonymous

        Thanks for your response, Jerry. So I was wrong, ESOP doesn’t work like a mutual fund.

  • Anonymous

    Good stuff – keep up the communications!

    • Jerry Ripperger, Director-Consulting, the Principal Financial Group, Princor Registered Representative

      Thanks. I appreciate your comments. I will be posting every couple of weeks so please keep reading!

  • Barb Mueller

    Great Picture of you Jerry!

    • Jerry Ripperger, Director-Consulting, the Principal Financial Group, Princor Registered Representative

      Barb – it is amazing what a good photographer can do!

  • Anonymous

    Great visual Jerry – thank you for sharing!

    • Jerry Ripperger, Director-Consulting, the Principal Financial Group, Princor Registered Representative

      They say a picture is worth a thousand words and in this case I couldn’t agree more.

  • Bruce Langness

    When an ESOP company claims to be 100% employee owned what does that really mean? For example can a company claim to be 100% employee owned when say 10% or more of the ESOP participants are non-employees? Is there an ESOP standard for this?

    • Jerry Ripperger, Director-Consulting, the Principal Financial Group, Princor Registered Representative

      Bruce, thanks for your question. When a company states that it is 100% employee owned it can mean a few different things. It may mean simply that it is a privately held corporation and all of the owners are current or former employees.

      In the case of an employee stock ownership plan, it typically means that all of the capital stock of the company is owned by the ESOP trust on behalf of the employees. If ten percent of the stock was held by others (even if they were employees but the stock is outside the trust), it wouldn’t generally be considered 100% employee owned.

      However, a note of caution. There is no governing body on what the definition of 100% employee owned means. When in doubt, ask the company.