What About Profit Sharing and Employee Stock Ownership Plans?

This article carries forward the theme started with a question about what to do when a company can’t or doesn’t want to offer stock options. My first response, “Competitive Compensation Without Stock Options,” covered units, phantom awards and appreciation rights. The world of Long-term incentives (LTI) is vast. Some companies get comfortable with one “family” of LTI and use it to augment every total reward program they touch. It’s sort of like putting catsup on every meal. Catsup might be great, but it isn’t ALWAYS great (although my wife and I often disagree on this issue).

This article provides an overview of Profit Sharing and Employee Stock Ownership Programs (ESOPs). These programs are similar in many aspects, but totally different in critical areas. First, some equity compensation programs are used to share profits. Other equity compensation programs are used to share ownership. Second, outside the U.S. the acronym “ESOP” is often used to refer to Employee Stock Option Plans. Third, smaller companies often fund their bonus or other variable compensation programs using profits. To be clear, this blog won’t be covering any of that stuff.

Profit-sharing programs are most often designed as a retirement benefit, but can offer a wide variety of vesting schedules. These are funded programs that generally require trusts to hold contributions, investment decisions, formal plan documentation, designated fiduciaries and other structural components. These programs create a direct link between one definition of success (profits) and employee compensation. They may disengage employees from other success measurements, so they often used to augment, rather than replace other plans.

From a compensation philosophy, these types of profit sharing programs focus participants on 1) profits (duh) 2) long-term employment with the company. While these plans are a legitimate alternative to stock options they obviously serve a very different purpose. If you are trying to link compensation over the next 1-5 years to some type of corporate success profit sharing, these programs are unlikely to be your solution.

ESOPs provide employees with a piece of a large block of company shares. These are also designed as a long-term program with payout available at retirement or other vested leave date. Company shares are purchased or contributed by the company and held in a trust fund. They provide support of a real ownership culture and also offer potential tax benefits to the company. These programs are often established when the owners of a closely held company wants to “cash out” on some or all of their ownership without giving control to some outside organization or the public at large.

The downsides to ESOPs are not insignificant. The cost to set up an ESOP can be prohibitive for a small company when compared to the set up costs to other LTI/LTB programs. There is also the real risk that if the company performs very poorly an employee may lose their job and retirement funds at the same time.

The upsides to ESOPs are well documented.  ESOPs offer significant tax benefits for both employees and companies. The National Center for Employee Ownership (a great resource) also says that ESOP companies generally outperform their peers in many categories. Lastly, I have worked with and been around many ESOP companies over the years and they tend to have very involved and passionate staff members. While true engagement can often be hard to measure, sometimes you can just a get a “feel” for it and ESOP companies often have the feel.

Your long-term incentive programs needs to be custom fit along with the needs of your company. You also need to be willing to explore new solutions as your goals change. When a program that has worked for a decade stops working, it might not just need a new paint job, you might need to trade it in. And, if your company has unique limitations on the use of certain types of pay tools (cash, equity etc.), you may need to speak to more than one expert to get to the right solution. Don’t wait to start that exploration. Even if everything is working great today, it is great to have your toolbox stocked with future solutions. I will touch on a few other LTI alternatives in my next post and then return to my standard, irreverent, analogy-filled posts.