Most companies that set up employee stock ownership plans (ESOPs) have a fairly simple capital structure: one class of common stock, which is the security sold to the ESOP. In recent years, however, many companies have begun to use different types and classes of equity securities in their ESOPs and other employee benefit plans. Companies have elected to use more complex securities to achieve various objectives related to taxation, compensation, corporate governance, and financial flexibility.

U.S. tax laws allow C corporations to use a broad range of security types in ESOPs. Securities that can be sold to a leveraged ESOP include all employer securities with the highest dividend and voting rights of all classes of common stock.1 In addition, an ESOP may purchase equity securities that are convertible into such a class of stock. Given this wide array of possible securities, companies have been very creative in designing complex securities that meet the basic legal requirements for ESOP securities. These complex securities also have special features to meet specific corporate finance objectives.

Types of Complex Securities Used in Employee Stock Ownership
and Other Benefit Plans
In this section, we describe some of the complex equity securities that have been sold to ESOPs. In addition, we discuss some of the ways in which these securities meet various corporate objectives.

Standard Convertible Preferred Stock
Standard convertible preferred is the most commonly used complex security in ESOPs. By standard, we simply mean convertible preferred stock that has dividend rates, call features, and conversion rights that are similar to those issued in the public markets by the typical public company issuer. A convertible preferred security gives the holder the ability to convert the preferred shares into a fixed number of common shares, thereby participating along with common shareholders in the growth of the company.
Before conversion, the preferred shares receive a higher dividend over a certain period of time. In exchange for this larger and more secure dividend, the purchaser of a convertible preferred security pays a price higher than the common stock for the security. The conversion premium is a measure in percentage terms of how much higher a price is required for the superior dividend rights. Dividend rates on newly issued public convertible preferred securities generally range from a few basis points below to 400 basis points above the rates on medium term Treasury notes, and conversion premiums at the time of issuance range from 15 to 30 percent.

Call protection is typically offered for two to five years. This call protection guards the convertible preferred security holder from having his or her financial advantage taken away during that period.