An employee stock ownership plan (ESOP) is a benefit plan that invests in the shares of the sponsoring company. An ESOP is a qualified plan under ERISA, which means that participants in the plan receive several tax benefits. The plan gives employees an ownership interest in the business, so they should be more inclined to make business decisions that will increase the value of the shares in the ESOP. Employee ownership of the shares in an ESOP vests over time, thereby encouraging employees to remain with their employer for a lengthy period of time. When a fully vested employee leaves the company, the ESOP grants them the shares to which they are entitled, which the plan may buy back from them at the fair market value of the shares. If the entity is a private company, fair market value is based on an annual valuation of the shares by a third party.
An ESOP should not be considered a perfect substitute for an employee retirement plan, since the plan’s assets are concentrated in ownership of just the shares of the company, which represents a very undiversified (and therefore risky) investment.