ESOP stands for Employee Stock Ownership plan. It is a deferred compensation plan that is based on equity. Under the system, the employees become owners of the stock in the company they work for.

The ESOP usually functions through a trust that buys the company stock using contributions from the company. These contributions are tax deductible. The company’s contributions are divided into individual accounts based on the salary and position. The employees have the option of cashing out either after vesting in the program or after leaving the company. Vesting is a process by which employees gain access to increasing portions of their account. The vesting requirements determine the amount they can cash out.

The vested portion is given to the employees at the time of termination, retirement, death or disability. The distributions can be lump sum or can be made in installments. In the case of death, the vested portion of their ESOP accounts goes to their beneficiaries immediately.

Many companies opt for ESOP to give incentives to their employees. They feel that giving the employees a share in the stock of the company would give them a sense of ownership and improve dedication. This assumption has been backed by research. It has been shown that employees would be more loyal and dedicated to the company which has an ESOP. This dedication translates into bottom line profits.

Before implementing an ESOP it is recommended that a feasibility study be made to find out the value of the stock of the company and the implications of the contributions on the ESOP trust. It is recommended that the plan be designed through an ESOP specialist.

Some of the advantages are :

- Capital appreciation: The ESOP allows companies to convert the personal and corporate taxes into tax-free appreciation by selling all or some of their equity to their employees. 

- It is incentive based: ESOP improves productivity as employees are more motivated to work for a company they partly own. This greatly improves relations between the employees and the management. 

- Reduction in taxes: A company’s taxes decrease as stock enters the ESOP. Many companies use this method to reduce taxes.

Disadvantages: 

- Liquidity: If the value of the company increases, the ESOP or the company will not have enough funds to buy back the stock. 

- The performance of the stock: If the company’s value does not increase, the ESOP loses its attractiveness to a profit sharing plan. The latter would seem more preferable. 

- The accountability of the fiduciaries: The members who are involved in the plan’s implementations are known as fiduciaries and can be held accountable if they are found to have knowingly participated in unlawful transaction. 

- Dilution: If the growth of the company is financed using the ESOP, the rate of dilution must be taken into account when calculating the cash flow benefits.