How does an ESOP work?

Written By:
August 19, 2021

As the name suggests, an ESOP (Employee Stock Ownership Plan) is a type of employee benefit plan that gives employees a stake in the company they work for. As a result, the employer has the sole discretion to decide which employees are eligible to participate in employee stock ownership plans.

Employee stock ownership plans (ESOPs) allow employees to purchase a specified number of companies shares at a defined price. As a result, before an employee can exercise his stock options, he/she must work for the company for a predetermined period.

How does an ESOP operate?

  • ESOP trust is set up by the company's management. If the existing owner does not want to sell shares, the company can issue new shares.
  • To buy new or existing shares, an ESOP can borrow money from a bank, while the company contributes money so the trust can pay back its loan.
  • In most cases, employees receive a share of the trust, which is distributed based on their relative salaries. As they continue to work for the company, their right to the shares increases, a process known as vesting. Everyone who works full-time and is older than 21 must be eligible for the plan. What does this mean? As a result, employees become owners of the company and have some control and voting rights within the company.
  • Stock is given to departing employees who must be bought back at fair market value by the company (unless there's a public market for those shares) when they leave. Employees are compensated for their shares through a trust, which usually pays out cash to employees in exchange for their shares.


To create an Employee Stock Ownership Plan, the company must first establish trust with its employees. These new shares or cash used to purchase existing stocks are contributed by a company into this trust.

A portion of these donations can be deducted from your taxes to the extent permitted by law. These shares will be issued to all eligible employees' accounts by the company.

In general, the allocation is based on the number of years of service or the compensation. When calculating the allocation percentage, the employer may even take into account both criteria. New employees can usually benefit from the advantages of the plan and receive allocations after accomplishing at least one year of customer experience or probation period.

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