What Is a Leveraged Employee Stock Ownership Plan (LESOP)?

What Is a Leveraged Employee Stock Ownership Plan (LESOP)?

Let me explain what a leveraged employee stock ownership plan, or LESOP, really is. It's an employee compensation setup where the company sponsoring it uses its own credit to borrow the funds needed to buy shares from its treasury. These shares go into the stock ownership plan, and the company pays back that loan through annual contributions.

Key Takeaways

You should know that a LESOP essentially uses borrowed funds to set up an ESOP as equity compensation for employees. The company borrows against its assets and repays the loan with those annual contributions. The main advantage here is that the company doesn't have to shell out cash right away to fund the ESOP. But remember, this involves taking on significant debt, so you have to approach it carefully.

Understanding Leveraged Employee Stock Ownership Plans (LESOPs)

Companies typically go for ESOPs or similar equity programs to link part of their employees' interests to the company's stock performance. This gives participating employees a real incentive to keep operations running smoothly and profitably. In fact, companies often use ESOPs as a corporate finance strategy to align employee interests with those of shareholders.

By leveraging its assets, the business can fund its stock ownership plan and give workers an ownership stake without putting up all the capital immediately. LESOPs take the proceeds from bank loans to buy company stock from the company itself or existing shareholders, at a price set by independent appraisers. The bank holds those shares as collateral and usually requires guarantees from the company, remaining shareholders, or selling shareholders.

Tax Considerations

LESOPs act as a tax-advantaged way to finance corporate growth because the shares allocated to an employee's account aren't taxed until distributions happen, which is usually after the employee leaves the company. Due to tax law limits on deductions, employer contributions for annual loan payments can't exceed 25% of a participating employee's annual compensation. Also, a company can restrict LESOP participation to employees over 21 who have at least one year of service.

Potential Downsides to a Leveraged Employee Stock Ownership Plan (LESOP)

Even with the tax-deferred benefits for LESOP participants, there are downsides, starting with the inherent investment risk. Since a LESOP often replaces other qualified retirement plans, it might lack the diversification of something like a 401(k), being too focused on company stock. Employees who are 55 or older with at least ten years in the LESOP can diversify 50% of their accounts over five years into other investments.

Plus, because it involves borrowing, a LESOP can hurt a young company's debt-to-income or debt-to-equity ratio, making it look less appealing to investors. And if the company can't repay the debts, the lender can take the collateral assets.