Leveraged Employee Stock Ownership Plan - LESOP

Categories: Company Management

See: ESOP. See: RSU.

It makes sense for companies to pay their employees in one form or another, with equity or part ownership in the company. That way, presumably, they behave more like owners than just employees.

When an ESOP (Employee Stock Option Plan) is leveraged, employees are essentially loaned cash to buy the stock or buy out the options they've been granted in the company. They are thus leveraged to the company...with teeth.

Related or Semi-related Video

Finance: What is a Qualified v Non-Quali...11 Views

00:00

Finance Allah shmoop What is a qualified versus nonqualified stock

00:08

option plan qualified for favorable long term gains tax treatment

00:15

Thank you very much if you have qualified stock options

00:18

a incentive stock options or ISOs as they're called around

00:22

Silicon Valley And yes those air relatively rare They're generally

00:25

on ly given to the very first I'ii single digit

00:28

number of employees joining a company Then those employees get

00:31

the benefit of being able to buy out their stock

00:33

options and having them become fully owned Common shares on

00:37

very favorable tax bases The ability to buy them out

00:40

not have to pay big taxes at the time you

00:42

do is a big benefit and well you'll see why

00:45

not just for the meaningful vibe of being able TTO

00:48

feel like and actually be a co owner of the

00:51

company But because it usually means that the employees investors

00:55

will qualify for much cheaper tax rates when they eventually

00:59

do sell if the employees does not buy out the

01:02

options While there's no difference in tax treatment that is

01:04

these options are treated just like the nonqualified non stock

01:10

options or en esos got it non stock options Gordon

01:13

ISOs Well the number which can be granted within a

01:16

companies E stop or Employee Stock Option Plan program are

01:20

limited And if a company violates this number by granting

01:23

too many qualified stock options well then the company is

01:27

taxed heavily as it is viewed by the IRS is

01:30

having used quote falsely cheap unquote stock to pay key

01:34

employees Catch Aly That's called the cheap stock rule applies

01:38

to our issues and some other things as well Well

01:40

the granting of these kinds of compensatory stock options can

01:43

only be given to employees slash insider's of the company

01:46

they have to be granted at a fair market value

01:49

strike Price III Whatever the four o nine evaluation calculated

01:53

by lawyers and bankers and bean counters said the company

01:56

was worth That's the valuation the strike price has to

01:59

reflect for the the common stock meaning they get an

02:01

appraisal from a bunch of bankers and lawyers And they

02:04

tell you what the common stock is worth today And

02:06

it's usually in an early stage company worth a whole

02:09

lot less than the preferred stock because the company's odds

02:12

of going bankrupt are really high at that point So

02:14

these type of stock options carry a maximum life of

02:17

ten years usually And then there are the ten percent

02:20

rules that is for at least ten percent of the

02:22

shareholders The exercise price of these options has to be

02:25

ten percent greater or more than the fair market value

02:28

of the company at the time Well because these options

02:31

receive such favorable tax treatment there strike price has to

02:34

carry a premium right That's that ten per cent thing

02:37

And lastly the maximum cap or value of the stock

02:40

options for any individual cannot exceed one hundred grand at

02:43

least in today's world as exercised or bought out in

02:46

any one year In other words they're designed only for

02:49

the very early employees with companies carrying very low valuations

02:54

E early start ups Okay so that's qualified stock options

02:58

The other end of the world nonqualified stock options Yeah

03:01

that's for the rest of us blue collar slobs Well

03:04

those options can in fact also be bought out But

03:06

upon that transaction employees are taxed as if they are

03:09

direct compensation and those taxes are levied as ordinary income

03:14

I either very high tax rates So in practice most

03:16

employees getting qualified stock options by them out almost immediately

03:20

And usually there's a negotiation before that employee has hired

03:23

such that their commitment to the company has made clear

03:26

by their tacit agreement to buy out their qualified options

03:30

and have financial skin in the game For employees with

03:32

nonqualified stock options and the buyout usually doesn't happen and

03:36

those options are viewed as well Gentle lottery ticket potential

03:40

big wins way down the line Should the company do

03:43

well that's not always the case Sometimes people buy him

03:46

out but the big tax treatment favorability eight there So

03:52

you and your roommate both joined Shmoop flicks early You

03:55

both received the same grant of one hundred thousand options

03:58

at a dollar a share strike price How was this

04:00

dollar calculated Well lawyers and bean counters were hired for

04:03

small feet to make their own valuation assessment of the

04:06

company And when they completed that review they determined that

04:09

if the company were sold today it's common shares would

04:11

command a dollar each on the open market or eBay

04:14

or Rush Watch or Fidelity or wherever the company was

04:16

sold That number's called the four o nine evaluation in

04:19

the strike price of those options applies to pretty much

04:21

all the flavors of options you know qualified or ISOs

04:24

and nonqualified stock options Unfortunately because you only majored in

04:28

E con your package gave you nonqualified stock options whereas

04:32

your roommate was an engineer So she received qualified stock

04:36

options Not a big deal of the time You didn't

04:38

really even care notice other than the one little thing

04:41

which was that your roommate borrowed one hundred thousand dollars

04:45

to buy out all of her options at that time

04:47

a risky move because of the company had gone bankrupt

04:50

or done poorly Well that hundred grand would have been

04:53

probably zero fast however because they were ice oes She

04:57

did not pay any tax on that exercise so pay

05:00

it when she sells them at a long term gain

05:02

Right Right So then along comes an Ai po and

05:04

the stock rocks in the four years Pass and Shmoop

05:06

Flix is conveniently for this example problem Hovering around thirty

05:10

one dollars a share it is thirty bucks in the

05:13

money and then you both go to sell well Your

05:16

roommate pays a twenty five percent ish long term gains

05:19

rate tax on the thirty dollars times one hundred thousand

05:22

or three million bucks That is she pays seven hundred

05:25

fifty grand in taxes to net to point two five

05:27

million You however pay fifty percent ordinary income tax on

05:32

the three million bucks in gain to net one point

05:35

five million And remember she had a hundred grand invested

05:39

with the company for four years and it took a

05:41

lot more risk than you did So if you're feeling

05:43

bad well tough beans you paid a lot of tax

05:45

so it's a good problem to have But wow the

05:48

little word non on your qualified options A plan cost

05:52

you seven hundred fifty thousand dollars of winnings in the

05:55

form of taxes Ouch So this sounds like Silicon Valley

05:58

magic where everyone gets rich and becomes a millionaire by

06:01

the time they finish their bar mitzvah speech Oh so

06:04

not the case In fact most startup companies in Silicon

06:07

Valley go fully bankrupt So had a tax avoiding Mohr

06:10

greedy than fearful employee about out all their options qualified

06:13

or not And then the company was sold for two

06:16

thirds of the value of its preferred stock investment Will

06:19

the common stock would be wiped out worthless and all

06:22

the money the employees spent buying out there ISOs would

06:25

be gone So the business of betting big on start

06:28

ups is not one for the faint of heart but

06:30

going in The presumption is that well you've carefully watched

06:32

this video and others on shmoop finance and you know

06:35

the witch and the warlock dance between risk and reward

06:38

makes sense you know make dollars

Find other enlightening terms in Shmoop Finance Genius Bar(f)