When considering employee benefit and owner succession plan alternatives, business owners often overlook the possibility of an ESOP – an Employee Stock Ownership Plan. In an ESOP, the company establishes a trust that invests primarily or completely in the stock of the company. Employees become vested in this stock, giving them an ownership and financial interest in the company. Upon leaving the company, and based upon the ESOP document, employees receive the amount of stock and cash in which they are vested. The company then buys back the stock (resulting in cash for the employee), usually transferring the repurchased stock to a different pre-tax participant account. For a company owner or shareholder, an ESOP provides a good exit strategy at retirement with significant tax benefits.
Although ESOPs have significant benefits for employers and employees alike, many business owners don’t consider employee ownership because they have fallen prey to one or more common ESOP myths and misconceptions:
Myth #1: I don’t have the right type of company.
The type of company is irrelevant when considering an ESOP. Both large and small, public and private companies can form ESOPs. S corporations as well as C corporations are eligible. What is important is that your company has stable cash flow, a history of stable or increasing sales and profits and an interest in providing employees with equity value.
Myth #2: An ESOP is expensive to set up and maintain.
Selling shares to an ESOP is typically no more expensive than selling shares to an outside party or family member. Even in sales to a family member, outside lawyers and consultants are hired, valuations are completed and the transaction is documented for tax purposes. Maintaining an ESOP entails annual costs of administration and appraisal, but these costs are typically far outweighed by the tax advantages Congress established for ESOPs.
Myth #3: My employees don’t have the money to buy the company stock.
In an ESOP, the employees are not typically the ones purchasing the stock. Rather, the company makes corporate tax-deductible contributions to fund the ESOP, or the ESOP can borrow money to buy the stock. If employees wish to buy stock with their own funds, that can be arranged, but it is a completely discretionary part of the setup of the ESOP, as it is higher risk and more costly.
Myth #4: My employees won’t have the security of diversification in their retirement accounts.
Three factors counter this concern: first, companies usually have a 401(k) plan or other type of retirement plan available in addition to the ESOP. Second, ESOPs are not required to invest exclusively in company stock; they can also have investments in cash and other securities. Third, by law, ESOP participants who are approaching retirement age must be given an opportunity to diversify up to 50% of their ESOP stock account.
Myth #5: The company will have to make a fixed contribution every year.
A recurring contribution, yes. An annual contribution, no, unless there is a loan involved with the ESOP that needs to be repaid. In fact, in some instances, it may be wise to make larger contributions to accumulate cash in the ESOP to counter years in which cash flow may be in short supply.
Myth #6: I will have to divulge complete financial data to my employees.
There is no requirement that an ESOP company must disclose detailed, or even summary, financial information to its employees. In fact, the only “financial” information that must be disclosed to ESOP participants is an annual statement showing the value and number of shares in their accounts. The value of shares is determined by the ESOP trustee, who must obtain an annual appraisal by an independent appraiser. This appraisal is not required to be disclosed to employees. The appraiser and trustee, of course, must have access to the company’s financial information to determine value, but this information is kept confidential and is not disclosed in any other way. That said, there may be, and often are, distinct benefits to providing full financial information to employee-owners, but this is not mandatory and is a choice.
Myth #7: I will lose control of my company.
Establishing an ESOP does not imply moving to a completely democratic business model; company leadership can and should remain intact and governed by a board of directors appointed by the ESOP trustee. This ESOP trustee, who is appointed by the company’s board of directors, is the legal shareholder of the ESOP’s shares and votes the shares for the benefit of all ESOP participants. In fact, voting rights in non-public companies are only passed through to ESOP participants for a relatively short list of items related to the company: sale of all or substantially all assets, a merger or consolidation, a recapitalization, a reclassification, a dissolution or a liquidation.
Myth #8: I will be stuck in it forever.
If your company needs change, you can terminate the ESOP. At that point, all participants become 100% vested and distributions must begin as soon as administratively feasible.
An ESOP is, without question, a valid employee benefit and owner succession plan alternative. It can also be much more than that, as it can be used to raise new equity capital, refinance outstanding debt, and acquire productive assets through third-party borrowing. By discarding the myths and misconceptions that surround ESOPs, you can accurately weigh the benefits of establishing an ESOP and make a strategic decision that will guide the growth and development of your company for years to come.
If you’re interested in pursuing employee ownership for your company, you can also check out our library of case studies, telling the stories of our clients who completed successful ESOP transactions.