ESOP v. Stock Options: What’s the difference?
We often get new clients asking for an ESOP Plan when they’re wanting to start equity plans for their employees and service providers. However, ESOPs aren’t typically used for startups and similar businesses in the U.S.; rather, most individuals are thinking of a Stock Option Plan or Equity Incentive Plan when they say “ESOP.” So, what is the difference between an ESOP and an Equity Incentive Plan?
Employee Stock Ownership Plan (ESOP)
In the United States, an ESOP, short for an Employee Stock Ownership Plan, is a type of ERISA qualified retirement plan set up by a business for employees. The ESOP allows employees to “own” part of the business as part of their retirement plan. Because an ESOP is ERISA qualified and a type of retirement plan (like a 401k), a trust must be formed and other legal documents must be signed to establish the plan. There are companies that specialize in setting up ESOPs and maintaining/administering the plans. Because of the level of regulation involved, setting up an ESOP can cost tens or hundreds of thousands of dollars. The plan also requires ongoing maintenance and tax filings. An ESOP is generally considered a very complex legal vehicle and tends to be used by very established businesses intending to operate for a number of years. An ESOP is ideal for a business that wants to include employees in ownership long term and provide a retirement vehicle for employees. ESOPs are designed for prolonged, sustained growth by a business, and for a business that intends to operate for 10, 20, or more years into the future. An Equity Incentive Plan, in contrast, is geared more toward a change of control and exit from the business by service provider employees in 3-5 years (or less).
Equity Incentive Plan (EIP)
An Equity Incentive Plan is a type of plan established to provide equity or stock options to service providers of a c-corporation. It is not typically used for limited liability companies (although other types of plans are available for LLCs).
The Equity Incentive Plan usually, but not always, allows grants of Incentive Stock Options and Non-Qualified Stock Options, Restricted Stock Awards, and Stock Awards to participants, depending on the circumstances. Establishment of an Equity Incentive Plan typically requires creating the Plan and model award agreements for each type of stock option/equity. Some ongoing legal help may be required for particularly complex grants to participants, but companies can often handle ongoing tracking/maintenance themselves or through an accountant. An Equity Incentive Plan usually costs a few thousand dollars or so to implement.
A startup may issue initial Restricted Stock Awards to key founders and early employees, then switch to issuing stock options for later employees and service providers under the Equity Incentive Plan. Most individuals are thinking of An Equity Incentive Plan when they say “ESOP,” but in the landscape of U.S. startups, ESOPS are rarely used.
So why the confusion?
In India and some other countries, an Equity Incentive Plan is called an ESOP, and the U.S. version of an ESOP does not exist. Hence the confusion, particularly for non-U.S. investors, founders, employees, and other service providers. However, in the U.S. the proper term is an Equity Incentive Plan, not an ESOP.
We hope this blog post has been informative. And hopefully you now know the difference between an ESOP and an Equity Incentive Plan as possible equity plans for U.S. companies.