An ESOP is a technique of corporate finance as well as an employee benefit plan. An ESOP can be used to finance ownership transition, raise new equity capital, refinance outstanding debt or acquire productive assets. ESOPs can also be used to increase cash flow by making plan contributions in stock instead of cash.
Since contributions to the ESOP are fully tax deductible, an employer can fund both the principal and the interest payments on an ESOP’s debt service with pre-tax dollars.
Dividends on ESOP stock are tax deductible if they are applied to repay principal of the loan made to acquire the company stock on which the dividends were paid. Reducing loan principal with pre-tax contributions and dividends generates significant tax savings, which in turn increases the ESOP company’s cash flow. This favorable tax treatment means that ESOPs are effective vehicles for financing ownership transition.
There is strong statistical evidence that employee ownership improves employee morale and productivity, and reduces turnover. Surveys conducted by The ESOP Association show that most Association members report improved employee morale and productivity from their ESOPs. A study by the National Center for Employee Ownership found that ESOP companies grew more than 5% a year faster than their non-ESOP counterparts, and that ESOP companies with “participative” management styles grew at a rate three to four times faster than traditionally managed ESOP companies. An article by University of Pennsylvania Professor Steven F. Freeman in 2007 summarized the extensive evidence on employee ownership and concluded that combining employee ownership with increased employee participation can generate “astounding” returns on investment, and it is now generally accepted that ESOPs, especially in participatively managed companies, can improve a company’s productivity.
For more information on the benefits of employee stock ownership plans, see our post on the benefits of ESOPs for all stakeholders.