What Are the Risk and Rewards of ESOPs

Have you recently been introduced to Employee Stock Ownership Plans (ESOPs) as part of your employment package? ESOPs offer a unique mechanism for employees to gain an ownership stake in the companies they work for, aligning their interests with those of shareholders.  These plans – which are used in both private and public companies – offer meaningful financial rewards but also come with important risks that employees should be aware of. 

This article outlines the key benefits and potential downsides that employees should weigh when evaluating their ESOP participation.   

1. Preferential Tax Treatment  

Formal ESOP plans are categorized as a type of qualified retirement plan under the Employee Retirement Income Security Act (ERISA). This classification provides significant tax advantages for employees: 

• Tax-deferred growth: ESOP accounts grow tax-free until they are distributed. Employees have the flexibility to roll over their ESOP balances into an IRA or other qualified plans (such as 401(k)) to further defer capital gains tax until retirement. 
• Net Unrealized Appreciation (NUA): Employees may receive a lump-sum distribution of employer stock from their ESOP. In this case, any increase in value above the cost basis is taxed at long-term capital gains rates rather than ordinary income tax when sold, potentially resulting in significant tax savings. 

These tax treatments make ESOPS one of the most tax-efficient employee ownership structures in the US.  

2. Liquidity Risks 

Liquidity – the ability to convert an asset or security into cash – is a major issue that plagues employees holding ESOPs in private companies. The majority of ESOP firms are privately held companies where there is no public market for equity. As a result, employees are forced to wait for liquidity events to realize the value of their equity, such as:  

• An acquisition 
• An Initial Public Offering (IPO) 
• A company buyback or secondary sale

Additionally, many startups have stringent restrictions surrounding the sale of vested stock through their Right of First Refusal (ROFR) and even outright bans on secondary sales. This makes it difficult or even impossible to sell your vested stock without prior approval.  

On paper, you may accumulate significant value through your stock holdings but that value remains unrealized until one of these exit opportunities occurs. This can create a “paper rich, cash poor” dilemma, especially for employees who require liquidity for personal expenses or tax obligations.  

Liquidity is arguably the single biggest challenge facing ESOP participants in private companies. Companies must plan proactively, and employees should seek to understand the terms, timing, and risks associated with their ESOP shares to make more informed decisions. 

3. Dilution Risks 

Dilution occurs when a company issues new stock, reducing the ownership percentage of existing shareholders – including employees holding ESOPs. Dilution is an important risk to understand as it affects the value and upside of your equity over time.  

This is particularly common in:  

• Startups and growth-stage companies raising capital through equity financing
• Companies expanding their ESOP pool to grant equity to new hires or executives 

Example: 

If you join a startup and receive stock equal to 1% of the company when there are 1 million shares outstanding, an issuance of an additional 1 million shares will result in your ownership dropping to 0.5%, assuming no new grant is made to you. 

While the value of equity stake may increase with company growth, dilution can still reduce your relative ownership and upside – especially if the company repeatedly raises capital or restructures the cap table.  

Employees have little control over dilution with such major decisions dictated by the board and majority shareholders. Excessive dilution can erode the value of your ESOP stake and limit the long-term financial benefits. 

Summary 

ESOPs can be powerful wealth-building tools—offering tax benefits, ownership alignment, and long-term financial incentives. However, they also come with real risks, especially in private companies where liquidity and dilution are ongoing concerns. 

To make the most of your ESOP, consider: 

• Understanding your vesting schedule and exit rights 
• Asking for details about liquidity windows and buyback policies 
• Evaluating your exposure to dilution over time 
• Seeking tax guidance before exercising or selling your shares 

By staying informed, you can better navigate the complexities of ESOPs and make decisions that align with your financial goals.