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 which 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 plan, 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 pretax participant account. For a company owner or shareholder, an ESOP provides a good exit strategy at retirement. Often, an ESOP may be the only market for a minority shareholder in a closely held company.
Unfortunately, although ESOPs have significant benefits for employer and employee alike, many business owners decide against them 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 a strong cash flow, a history of increasing sales and profits, and a substantial interest in providing employees with equity.
Myth #2: An ESOP is expensive to set up and maintain.
Certainly ESOPs do have legal and administrative costs, but not excessively so. Setting up the ESOP may cost $50,000 to $100,000, with annual administrative and appraisal expenses running perhaps a third of that amount. However, the benefits to both employer and employee can easily make this a very worthwhile annual investment.
Myth #3: My employees don’t have the money to buy the company stock.
Although an ESOP is an Employee Stock Ownership Plan, the employees are not the ones purchasing the stock: the company makes corporate pretax contributions to fund the ESOP, or the ESOP or the company can borrow money to buy company 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 may be and often are distinct benefits to providing full financial information to employee-owners, but this is not mandatory. Companies are only required to share statements documenting the total value of the account, vesting and stock value.
Myth #7: I will lose control of my company.
Remember that ownership does not equal control. While in non-public ESOP companies voting rights on shares allocated to ESOP accounts must be passed through to ESOP participants for votes on major corporate matters, other decisions can be voted by a named fiduciary or as otherwise designated in the plan. Often, this fiduciary is the selling shareholder of the stock, who takes that position after the sale of the stock to the ESOP has been completed. Additionally, wise employees recognize that decisions should be made by those individuals most qualified to make them. In other words, establishing an ESOP does not imply moving to a completely democratic business model; company leadership can and should remain intact.
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 percent vested and distributions must begin as soon as possible.
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.