What is an ESOP?

An ESOP is an Employee Stock Ownership Plan. When a company sets up an ESOP, they are organizing a program that allows employees to own part of the company that they work for through the ownership of stock options.

The way that a company sets up an ESOP is by creating a trust. The company then makes contributions to this trust annually. A company can contribute to the trust either in the form of cash that is then used to buy stocks, or by donating stocks themselves, or a combination of the two.

Distributing stocks to employees through an ESOP

The stocks or the money that has been contributed to the trust fund by the company is distributed to employees through a number of different possible ways. Here are some of the options that companies have to distribute the stocks to the employees:

1. allocate contributions in proportion to the amount of compensation that the employee receives.
2. allocate contribution according to the number of years the employee has worked for the company
3. allocate contributions in proportion to a combination of years of service to the company and the amount of compensation

The way that distribution generally works is that an employee will join the ESOP. After one year of working for the company, the employee then can begin to receive allocations of the contributions made by the company to the trust fund. The way that most allocation works is that a year doesn't count unless the employee works for at least 1000 hours for the company during that year.

The vesting principle

Before an employee is entitled to receive the stocks and other methods of contribution set aside in an ESOP, the assets must "vest." "Vesting" is the name for a particular process in which employees end up becoming entitled to more and more of a percentage of the account as time goes on. This means that even after the first year of service, the employee probably will not be receiving the full 100% of his or her allocated shares or assets.
The rule governing vesting states that the most conservative vesting schedule must award an employee 20% more of the assets owed per year until the employee is fully vested. This occurs after the employee has worked for 7 years in the company. Of course, a company has the option to fully vest an employee sooner than this 7 year period. It simply can't take longer for the company to vest an employee.
ESOP diversification options

The law states that the following guidelines must be followed when it comes to diversifying an ESOP:

1. If an employee is 55 and has worked for the company for at least 10 years, then he or she:
   • must be able to diversify his or her ESOP for up to 25% of the value of the ESOP, if desired.
2. 2. When an employee reaches the age of 60, he or she has the option to diversify up to 50% of the ESOP account.

The vested portion

When an employee is terminated, suffers a disability, retires, or dies, he or she receives the entire vested portion of his or her account. This payment can be made in installments or in a lump sum. In the case of death or disability, the ESOP is received immediately in one lump sum.

If a company is publicly traded, the employee can sell the distributed shares. If a company is privately held, then the employees have the option to sell for 60 days after the date of distribution. Another option to sell must be given one year later.