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ESOP Share: Advantages and Disadvantages
ESOP Shares

ESOP Share: Emplyee Stock Ownership Plan

Employee stock ownership plans, ESOP Share or ESOPs, are a form of a company program that presents themselves to employees as incentives, pay, or investment possibilities. 

An ESOP’s main objective is to provide employees with the opportunity to purchase stock in their employers. 

Understanding the benefits and drawbacks of this kind of employee ownership and compensation will help you make better-educated judgments regarding the ESOPs that have been offered to you. In this post, we define ESOPs and describe their operation, as well as the benefits and drawbacks of having them. We also go through the various ESOP forms.

What is an ESOP Share?

Employees who participate in an employee stock ownership plan, also known as employee share ownership (ESOP Share), receive ownership interests in the business where they work. Owning stock in a firm entails possessing a unit of capital, or a portion of its assets and earnings. You can consider yourself a part owner if you have stock in a corporation. Employee interests and shareholder interests can be aligned through employee stock ownership arrangements. If an employee owns stock in the firm, they could put forth more effort to help the business succeed.

ESOPs may also be used similarly to a Registered Retirement Savings Plan (RRSP). By focusing on an employee’s performance at work and giving them incentives to work effectively for their employer, ESOPs aid in streamlining a company’s culture.

Why Companies Offer ESOP Share to its Employees?

An ESOP has a contribution plan that outlines the advantages provided to workers, sellers, and businesses. They are the main form of employee ownership and urge them to act, think, and conduct like owners to support the success of the company. ESOP share ownership plans can be used by businesses to:

  • Provide a profitable market for the ESOP share of retiring owners to entice workers and boost morale
  • Reward staff for their dedication and 
  • Success by using pre-tax funds and incentives to acquire assets.
  • After taxes, lend money at a reduced rate and pay staff.

Stock from the firm may be acquired through an ESOP and held for employees without cost to them. Employee stock ownership programmes function fundamentally as follows:

  1. By establishing a trust, the ESOP share  will be held on their behalf by a special kind of legal body.
  2. Contribution or borrowing of funds: The employer of a trust beneficiary may make a contribution to the trust or may borrow funds from a third party. Leveraged ESOP, a strategy that many businesses and organizations employ for these kinds of plans, is when a firm borrows money from a seller or bank.
  3. Buying firm shares: The trust purchases a certain number of shares from the company using the borrowed or donated funds. The cost of these shares is determined by a third party or hired appraiser.
  4. Share distribution: If the corporation is employing a leveraged account, the shares are allocated when the loan is paid off rather than being distributed evenly among the employee accounts. The employee then formally joins the firm as a shareholder.

 

How Annual ESOP Share Price is Determined?

The value of the ESOP shares may be determined by a third-party valuation firm using any combination of the income method, market approach, and/or asset approach, similar to how the value of a privately-held company is determined. A investor frequently uses many methods to assess the value before comparing and contrasting the outcomes to arrive at a final judgement on value.

Income Strategy

The income approach used in majority of yearly ESOP assessments combines the capitalization method with discounted cash flow method (DCF). Both approaches make an effort to measure the company’s potential to generate cash flow in the future. The proportionate perceived risk of generating those anticipated future cash flows is taken into account by each strategy.

  • The capitalization technique uses past performance as a stand-in for expected future outcomes. To calculate the value, historical outcomes are multiplied by a capitalization rate.
  • In the DCF approach, future cash flows are estimated using an explicit, multi-year projection and then discounted to present value.

Market Strategy

The market strategy is frequently employed, although not as frequently as the revenue approach. The guideline public company (GPC) technique and the transaction method are two more commonly recognised approaches used in the market approach.

  • The GPC technique looks for publicly listed firms in the same sector that are ideally direct rivals and not much bigger than the subject firm. To determine how the market might value the subject firm if it were publicly listed, the valuer performs both qualitative and quantitative modifications to the market price of the selected publicly traded companies.
  • The price of comparable businesses that were purchased or sold is examined in the transaction technique. To decide what multiples should be applied to the metrics of the subject firm, the valuator will compute and evaluate the valuation multiples at which they were purchased or sold. In this procedure, both qualitative and quantitative aspects are taken into account while selecting and changing the right multiples.

Asset Method

The asset approach is the one least frequently utilised in ESOP evaluations. By deducting the anticipated market value of the company’s obligations, this method attempts to determine the market value of the company’s assets. The equity worth of the business represents the balance. This approach may be adopted by an asset-heavy business that struggles to provide steady, sufficient cash flow.

Steps Followed to Find out Annual Value of the Shares

Here are some of the popular methods for valuing shares:

The Asset-based Strategy

This method is based on the NAV and share value of the firm. Here, the value of each share is calculated by dividing the company’s Net Asset Value (NAV) by the total number of shares.

The difference between a company’s net worth and its total liabilities represents its net asset value.

To ascertain the actual worth of a share, the net value of assets must be divided by the number of equity shares.

The following are some key considerations when valuing shares using this method of analysis:

  • It is necessary to take into account all of the company’s assets, including current assets and liabilities such trade receivables and payables, provisions, etc.
  • It is necessary to take into account fixed assets at their realisable value.
  • The computation requires the valuation of goodwill as an element of intangible assets.
  • It is advisable to get rid of fictitious assets like upfront costs, discounts on the issuance of shares and debentures, accumulated losses, etc.

The Income Approach

The income strategy focuses on the anticipated returns on the business investment, or what the company will produce in future.

The Value per Share technique is one of the most used approaches in this field.

Here, the price per share is determined using the company’s profit that is available for distribution to shareholders. By subtracting reserves and taxes from the net profit, this profit may be found.

The procedures below can be used to calculate the price per share:

  • Determine the amount of the company’s profit that is available for dividend distribution;
  • Identify the relevant industry’s usual rate of return; and
  • Subtract the rate of return from the profit for distribution to arrive at the capitalised value.
  • Divide the number of shares from this value.

Advantages and Disadvantages of ESOP Shares

Advantages of ESOPs

ESOPs have a variety of benefits, such as:

  1. Flexibility: Investors have the option of selling simply a portion of their shares or making a series of small withdrawals over time. They could still be employed even after selling their ESOP part in the company. If a worker retires or leaves company, they have choice to preserve their ESOP share, preserving their ownership of company.
  2. Data privacy: Employee information is kept private by ESOPs. This suggests that member data is secure and confidential. ESOP terms and conditions are reasonable, free of ambiguity, and they offer support to employees in times of need.
  3. Simple: Due to their ease of transfer, ESOPs are an excellent solution for retirement planning. They provide employees the opportunity to own a portion of the company for as long as they like. If they so desire, they may even sell a portion of it back to the company. Giving employees a part in the business allows owners to promote compensation and production. Employee productivity and corporate culture are both improving. When employees retire, the company can then repurchase their ESOP shares and continue to pay their pensions.
  4. Leadership consistency: Increased management and employee retention might result in consistency, lower turnover, and a stake in the company’s success. Employees have the opportunity to vote, get updates on plan descriptions and yearly statements, and learn about the organization’s accomplishments. These lines of communication help to develop concentration and align everyone’s interests inside the business. The corporate culture encourages teamwork among employees and promotes a positive work environment.
  5. Employees benefit because: When a firm gives ESOPs to its staff, it is likely to minimize employee turnover, which can increase job security and improve employee retention. Productivity rises in organizations that show a genuine interest in their staff members, which eventually helps the business make more money and expand more quickly. Generally, you may invest before taxes and get ESOP payments that are tax deductible. Since ESOPs are tax-exempt trusts, cash flow grows as a result of compounding interest over time.
  6. Fair Market Value (FMV) is Paid to the Sellers: FMV is the amount a business would sell for on the free market, according to the Internal Revenue Service. It is the amount that a willing buyer and a willing seller would agree upon if neither party was under any obligation to take any action and both parties had a reasonable understanding of the material facts. It is the fiduciary duty of an ESOP trustee to preserve this standard. An impartial valuation (esop share valuation) is used to determine FMV, then the plan’s sponsor and an ESOP trustee negotiate the amount. Only when both parties concur on a price is the deal finalized. A business and its shareholders might anticipate receiving just recompense for their equity overall.
  7. A Known Buyer is an Employee Trust: Due diligence in M&A transactions might reveal a seller. Sensitive firm information and trade secrets may be made available to rivals even if a transaction is not completed. The buyer, an employee trust, ultimately has the company’s best interests in mind, even though a leveraged ESOP transaction should go through a comparable, meticulous fact-finding procedure. A solid and effective plan sponsor is the foundation of a successful employee stock ownership programme. Professional ESOP trustees are required to seek fair market ESOP value (esop share valuation), but not at the expense of the business’s standing or potential.
  8. Accessible Non-Recourse ESOP Financing: ESOPs are popular with commercial lenders. Increased cash flow is driven by the accompanying tax benefits (see below), and organizations with strong employee ownership cultures statistically outperform their counterparts. Senior loans with suitable terms, given without personal guarantees, may frequently fund a large chunk of a leveraged ESOP deal. If more upfront money is required, a higher interest rate mezzanine loan is also an option. These loans are repaid by employee-owned businesses using pre-tax company funds.
  9. Tax advantages for all parties: The creation of employee-owned businesses has been explicitly supported by Congress since the Employee Retirement Income Security Act of 1974 (ERISA) was passed. Significant ESOP tax advantages were incorporated in the historic legislation with the aim of working class wealth development and middle-market firm stability. These benefits have since been enhanced by lawmakers from both political parties.
  10. Independence, Potential, and Flexibility: Unlike an outright sale to a third party, an ESOP transaction may aid in preserving a company’s heritage while ensuring leadership continuity. Minority interest sales are frequent, and as long as at least 30% of the firm is transferred to an employee trust, stockholders are still eligible for capital gains tax deferrals. Board of Directors of a corporation will continue to run company even if a majority or 100% ESOP sale occurs. Selling shareholders are always able to continue playing important roles within their organizations. As a result, family company founders and important stakeholders remain involved. Any stakeholder may benefit when ESOPs are successful. Employee owners with vested interests and shareholders with retained interest directly profit from a company’s expansion. In an ESOP transaction, synthetic equity (or warrants) may also be given to selling stockholders. They too might continue to have upside potential as a result.

 

Disadvantages of ESOPs

There may be challenges in obtaining ESOPs, as there are with most incentive and pay schemes. The following are some possible difficulties with ESOPs:

  1. There are restrictions on price per share: The performance of the firm affects ESOP share price. Without sustainable earnings, the company’s esop value declines (esop share annual value), which might cause the ESOP share price to change. ESOPs are best for workers in businesses with a well-established management strategy that generates predictable and consistent financial returns.
  2. Timing: Based on company success, employees may need to timing their leave in order to maximize the ESOP value. A reduced payout will be received if you leave the business when the esop share price is lower. Therefore, time is crucial to take into account when choosing when to sell shares.
  3. ESOP Share prices change in accordance with business performance, which can make retirement planning difficult. Due to this discrepancy, if you have ESOPs for retirement, you might want to think about looking into additional choices, such as a Registered Retirement Savings Plan (RRSP) or Tax-Free Savings Account, in addition to this plan to assure financial security (TFSA). For those who own ESOPs but are unclear of or unable to anticipate the complete ESOP value after retirement, these programmes offer supplemental income.
  4.     ESOPs Need Constant Upkeep: Because an ESOP is a qualified retirement plan, even if it invests mostly in employer stocks, it is also subject to ERISA regulations. The DOL mandates that plan sponsors conduct yearly, independent appraisals and file a Form 5500. In addition to setting specific guidelines on stock allocation, vesting, and repurchases. The plan is managed on a day-to-day basis by a third-party administrator (TPA), just like other defined contribution plans, such as 401(k)s. The TPA also oversees annual disclosures, vesting plans, and ESOP share  repurchases. The expenses are comparable to those of other contribution programmes.
  5. Although there are several third-party: ESOP lenders, the majority of deals contain a seller note element. Selling Shareholders Frequently Provide Partial Financing the fundamentals and sector of a firm have a big impact on how much seller financing is offered. Some companies also favor transactions that are entirely funded by the seller. A private equity sale better suited for owners looking to sell shares with sole purpose of maximizing cash upon closure. However, their capital gains will be taxed, and it’s possible that sellers would need to roll stock into the transaction.
  6. The Process of an ESOP Transaction is Highly Structured: The US Department of Labor oversees ESOP regulation, and the IRS has defined official guidelines and limitations. Because of this, employee ownership transactions involve difficulties that are uncommon in standard M&A negotiations. The procedure involves particular processes, such as figuring out which employees participate and writing an ESOP plan and summary description. In addition to dealing with designated professionals (an institutional trustee, trustee’s counsel, and an independent valuation company).  Additionally, there is a requirement to inform the personnel about their new benefit programme. All of this emphasizes how crucial it is to collaborate with knowledgeable employee ownership experts. Despite these subtleties, the price to accomplish a leveraged ESOP sale is typically lower than the price to complete an M&A transaction or a private equity translation (esop share price calculation).
  7. ESOPs Cannot Offer More Than FMV: Acquisition targets may have special synergistic advantages. Certain acquirers’ objectives for vertical integration, horizontal expansion, or market ESOP share  can be best achieved by certain companies. A strategic buyer may pay a premium above the FMV price provided by an employee trust if they believe the transaction will result in economies of scale. Although the tax benefits of an ESOP can assist reduce or eliminate this gap. There are times when a strategic sale will be the most cost-effective choice in terms of post-tax sale profits.

Conclusion

Finally, it’s crucial to remember that an ESOP isn’t always the best option. Share buybacks and secondary ESOP sales are frequent following moves. Even employee-owned businesses have the option to participate in M&A. Of course, employee owners receive a portion of the revenues if an ESOP firm is sold. That may transform an experience that is typically unpleasant for workers into something good and life-altering.

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