ESOP Communications Tip: Leverage Your Leverage

If you have a leveraged ESOP, each year you contribute some percentage of compensation to make payment on the debt. Let's say that's 8%. You could say, then, that you make an 8% per year contribution to the ESOP. That's good—more than twice what typical companies put into matching 401(k) contributions. But 8% is not what employees actually see added to their accounts each year. What they see is the value of the shares released from the suspense account. If the share value goes up, that will go up past 8%.

Let's say a company called Legacy Inc. sets up an ESOP. The ESOP buys 100,000 shares at $50 per share with a 10-year loan. Each year, the company contributes 8% of its $625,000 annual eligible payroll to the ESOP to repay the loan and pay for $10,000 shares. Say Sally makes $62,500, or 1% of eligible pay. She gets an 8% contribution to her account from the company, and that contribution equals $5,000 in year one.

In year two, the shares go from $50 to $55. Sally gets that same 8% contribution, but the shares that go into her account are now worth $5,500, or 8.8% of pay. If the company continues to do well, maybe after year seven, the stock is worth $120. Now Sally sees not $5,000 added to her account that year, but $12,000.

The effect of leverage is much the same as with a mortgage. If you buy a $300,000 house with $50,000 down and it doubles in value over 10 years, your $50,000 investment yields $250,000 in gains, minus whatever the added costs of owning the home versus renting might be.

Just as with a mortgage, however, the leverage effect can go the other way. Fortunately, ESOP companies have performed very well, so most employee-owners are more like Sally. That means the money put into an ESOP by a company can be a lot more valuable to employees than money put into a 401(k). Helping employees understand that can make the ESOP a more powerful incentive.