The concept of ESOPs was devised by Louis Kelso in the 1950s. A lawyer and investment banker by profession, he felt that ESOPs would be an innovative way of allowing employee ownership in corporate undertakings. ESOPs are quite different from stock options to the extent that they are eligible for tax benefits and can prove to be a mechanism of tying your employees' performance with that of your firm.

The way to employee retention. Generally ESOPs are designed in such a manner that they become invalid if the employee leaves the firm before a specific period. Hence, employees have an incentive to stay on atleast as long. This period, referred to as the vesting period, could be anywhere between 1 to 5 years. Hence, the ESOP can serve as a means of retention.

Affording tax benefits. An ESOP is considered a retirement or benefit plan and is therefore eligible for specific tax cuts. For one, taxation is deferred until the stocks are distributed. Any capital gains from the stocks are taxed only when they are sold and even that can be avoided if the shares are sold back to the company. Even the company can deduct its ESOP contributions within limits.

Preparing for an ESOP. To establish an ESOP, your company will have to set up a trust fund and make yearly contributions to it. ESOPs are typically offered when the employee has completed a specific tenure. According to a new ruling in the U.S., once an employee completes 10 years or attains the age of 55 he or she must be given the option of diversifying upto 25% of their holdings and at age 60, this limit increases to 50%.

Pros and cons. There are some clear benefits for both sides. For the employer, this works as a method to control attrition and doubles up as a motivational tool. Employees benefit through their ownership in a fast growing company. It also works as a good benefit package. The drawback however, is the fact that setting up and monitoring an ESOP is costly. Likewise, the returns from an ESOP depends upon the firm's performance and is hence, quite unpredictable.

ESOPs vs stock options: Yes, there is a difference and you must know it! An ESOP does not involve the purchase of stocks by employees; instead the firm gives its own stocks to the plan and employees satisfying a minimum set of requirements are entitled to receive them. Stock options, on the other hand, enable employees to buy the shares of the company at discounted rates. If stock options bring in new capital, it can impact the Earnings Per Share (EPS) negatively. Alternatively, companies often buy back stock from other owners to offer options to their employees so that the capital remains unchanged. Also, the tax benefits from ESOPs far outweigh their costs and hence they have an edge over stock options.

“Sharing Ownership: The Manager's Guide to ESOPs and Other Productivity Incentive Plans” by Darien A. McWhirter, available at amazon.com can help you design your ESOP.

There are other benefit plans that seem similar; hence be careful while deciding what plan to adopt for your firm. ESOPs are a very innovative corporate practice and can bring benefits to both the employer and employee when designed appropriately.