Employee Stock Ownership Plans (ESOPs)

A well-managed employee stock ownership plan (ESOP) can add tens, if not hundreds of thousands of dollars to your net worth over the long term. Employee stock option plans grant you rights to purchase shares of company stock for prices beneath their market value. ESOPs, however, do expose both employee shareholders and non-employee investors to significant financial risks. All prospective investors should become familiar with how these plans are structured, before committing capital.

Strike Price

Employee stock options, again, grant rights for you to purchase shares of company stock at a set strike price. You will exercise employee stock options when the strike price is less than the stock market price for company shares. For example, you may be granted employee stock options that carry rights to purchase shares in Company Stock or $50. You would consider exercising your stock options, for an immediate profit, if Company Stock were to trade for well above $85 per share in the stock market.

Corporate Strategy

Corporations grant employee stock options to align outside shareholder interests alongside those of insider employees. Employee stock options gain in value as company stock prices appreciate. Corporate managers are therefore motivated to take actions that drive company share prices higher – to improve their respective level of compensation through employee stock options.

Taxes

ESOPs present complicated tax ramifications – because they combine employee compensation alongside an investment component. Tax issues are triggered when you exercise employee stock options, and not when the options are actually granted.

When you exercise options, the difference between your strike price and market value for company stock may be treated as employee compensation and subject to ordinary income taxes. For example, you may exercise stock options to buy Company Stock shares for $50, while it trades for $85 in the stock market. You may then owe taxes on $35 worth of ordinary income. In three years, you may be able to sell Corporation X shares for $150. At that point, you would be subject to capital gains taxes on the $65 in realized profits ($150 – $85 = $65).

Investment Strategy

ESOPs expose existing shareholders to dilution, because the corporation may be forced to issue new shares of stock when employees exercise options. At that point, each individual share would represent a smaller ownership percentage of the corporation. To guard against ownership dilution, a corporation can spend cash to buy back its own stock. The corporate balance sheet and statement of cash flows will articulate the amount of outstanding common stock on the books and management’s stock buy back policy.

As an employee, ESOPs can leave your finances too concentrated within one company. If your employer were to fail, you would be out of a job, at the same time that your company stock options and shares become worthless. To manage financial risks, you may consider selling company shares immediately after you exercise options. From there, you can direct the cash proceeds into a diversified stock market portfolio.

Remember Enron.