Employee-Owned Companies

Is an employee stock ownership plan (ESOP) right for your business?

Read about the pros and cons of selling your business to an ESOP—from tax implications to employee engagement to the transaction process—and discover if your business is a good candidate for an ESOP.

Business owners have many options when it comes to exit planning. While all options have their advantages and disadvantages, more and more owners are considering the employee stock ownership plan, or ESOP.  Selling to an ESOP provides a vehicle for transferring ownership of the company to its employees—either in full or in part—but that is only a small part of the equation that business owners need to consider while contemplating an ESOP transaction. While ESOPs can come with a variety of advantages for the sponsoring company, the selling shareholders, and employees (e.g. favorable tax implications, rewarding employees, preserving company culture), there are also trade-offs that owners need to be aware of as well.

Read on to see if you and your company are good candidates for an ESOP transaction and if you should consider one as part of your exit strategy and succession plan. 

What is an ESOP?


At its most simple, an employee stock ownership plan is an employee benefit plan that invests in the stock of the sponsoring company. It provides a mechanism for employees to reap the rewards of business ownership and also provides significant benefits for the company. When you offer an ESOP, you are introducing a variety of tax advantages for your business and incentives for your employees. 

ESOPs were rare until 1974. Since then, they have become “the most common form of employee ownership,” per the National Center for Employee Ownership (NCEO). Today, there are almost 6,700 ESOP plans in the United States, encompassing some 14.4 million people – with good reason. ESOP-based incentives open doors that you won’t find in other options. Employee stock ownership plans let you offer new and novel ways of rewarding your employees. You can give them stock options or reward industrious employees with the ability to participate in a profit-sharing plan. Most importantly, though, employee stock ownership plans can provide substantial tax benefits to the sponsoring company and an exit strategy for the business owner that preserves the company legacy. 

Why Create an ESOP?


Manufacturing company teamEmployee stock ownership plans are more than employment perks or a way to get your people excited about your company’s growth – especially if you have a private company. 

“ESOPs can be a great way to help incentivize employees through the participation of company ownership, with potentially no out of pocket costs to the employees, while also creating a market for private company stock,” says Mills Snell of Pendleton Street Advisors. “Strong tax incentives that help moderate large capital gains tax consequences help steer many founders and entrepreneurs towards ESOPs.”

Exit Strategy Tool

One of the most common reasons to offer an ESOP is to facilitate an exit strategy for shareholders. ESOPs can be an exceptional tool to leverage in the succession planning process, both for liquidity and transition. The NCEO reports that roughly 67 percent of employee stock ownership plans in the United States are used to manage the shares of a company’s owner or another shareholder when they leave the company or are contemplating another transaction.

The ESOP structure lets you effectively transfer ownership from one or several shareholders all at once (100% ESOP) or piece by piece in a controlled manner (partial ESOP).  Owners who decide to sell their stake in the company over time can also retain their ability to stay involved in the business. It's the ease of transition and the flexibility of the transaction that can be the most enticing reasons to sell to an ESOP.

Employee Benefits

Employee stock ownership plans have a structure that allows employees to possess beneficial ownership, but not “actual” ownership. This lets you create an environment that helps you motivate employees to increasingly higher levels of productivity as well as foster employee loyalty and retention. In turn, this leads to higher profits and lower turnover.

According to a survey from the ESOP Association, roughly 77% of companies that offer an ESOP see increased profitability, and around 78% report an increase in sales. 

What Makes a Business a Good ESOP Candidate?


Employee stock ownership plans have so many benefits that it can be hard to remember that they don’t work for everyone. Some companies are going to be in a better position to enjoy the advantages that ESOPs have to offer. The more you understand what makes a business a good candidate for an employee stock ownership plan, the better you will be able to decide whether you should offer an ESOP at your company. There are many nuances to this decision, and you as a business owner owe it to your company to speak with advisors who specialize in employee stock ownership plans early in the process.  The earlier you look into ESOPs, the more prepared you will be if (or when) you make a decision rather than waiting to look into an ESOP when it's "crunch time."

About the Company

For the right situation, ESOPs are a great option – but you have to check the boxes. Work with an ESOP expert and start planning early. Remember, the decision to offer an employee stock ownership plan is a very intricate business decision. There are lots of moving parts and many options. An ESOP expert can guide you through the process.

Companies that offer employee stock ownership plans have to start with a solid foundation, meaning that the company financials should be reliable and consistent. These organizations need to have adequate cash flows to support the ESOP structure along with a strong employee base (i.e. the company's overall payroll should be robust enough to avoid potential contribution limitations). 

You will also want to make sure you are profitable – otherwise, you won’t get the same tax benefits, and the costs could be prohibitive. Also, look at who you want to have access to the program. If you're going to want to pick and choose participants, an ESOP plan may not be the best choice. While exceptions exist, you generally have to allow any full-time employees to participate that meet certain eligibility requirements (e.g. age or total years of service), but the requirements are dependent on the plan document. 

Further, you should know that ESOPs can only be used by C and S corporations. If you have a partnership or other business structure, offering an employee stock ownership plan is not going to be an option, or you may simply need to make adjustments before it can be an option. Some companies will see enough benefits from offering an ESOP that they will change their business structure to a C or S corp to accommodate an employee stock ownership plan. Talk to your ESOP expert to learn more.

It's helpful to have a strong management team in place that can help facilitate a smooth transition of leadership over time. As shareholders retire, the company will need to leverage these people and the structure you put in place to continue to run the firm profitably.

leaders ownersAbout the Owner

The owner of the company makes a big difference as to whether an ESOP will work, too. If your company couldn’t run without you, an employee stock ownership plan may not be a good fit. Introducing an ESOP is a game-changer. You could go from 100% ownership to letting key employees have a stake in the future of your company.

Similarly, your company’s culture could evolve to one of ownership – and that may mean significant changes for you as a business owner. You may be required to have independent board members and give up absolute control over your own company. If that fits with your goals, great, but it may not. Be realistic about your goals for your company and how much control you are willing to give up.

Also, look at your personal exit plan. Offering an employee stock ownership plan means that you will not be able to have a quick sale and it may be some time before you are entirely removed from the business. You might want to consider legacy as well. Employee stock ownership plans provide a way to protect your company’s culture, today, and going forward as well.

In many cases, the benefits will outweigh the costs, but they can be significant, so be sure to carefully evaluate what an ESOP would look like for your organization. If you simply want to sell your company, you can work with your financial advisor to evaluate other options, such as finding a strategic buyer or selling to private equity. However, if you would like to transition out of ownership and secure your financial future while improving your operations, ESOPs are an option that should be considered.

Benefits of an ESOP


Employee stock ownership plans have a variety of advantages—both for your company’s current financial situation and its future.

Community

If your company is a major employer in your area, you may want to preserve its standing in the community as a way of maintaining your legacy. Including the right employees will help your business succeed even after you leave. This can be a significant benefit if you do not have an heir to whom you would like to pass the company or partners you want to succeed you. Your firm has an impact on other companies in the area and could attract new employers to your region if your business remains successful.

Selling Shareholders

Many companies struggle with how to sell minority interest holdings as shareholders retire or move on to other opportunities. Closely-held firms can alleviate this difficulty by adopting an employee stock ownership plan. When you offer an ESOP, you are creating a way to sell shares of your company without introducing them to the market at-large. The company forms a qualified exchange for your private equity. Plus, having an employee stock ownership plan lets you sell shares tax-deferred as long as you meet certain parameters – namely that you have a C corporation and that the ESOP buys 30% or more of the outstanding shares. Creating shareholder liquidity does sacrifice ownership, but over 40,000 companies in the United States have taken advantage of the ESOP opportunity over the last 35 years, and more are joining their ranks all the time.

Employees

Employee stock ownership plans offer a variety of tax benefits to employees too. ESOPs are considered qualified retirement plans, so your workers do not have to pay taxes on the value of the amounts they receive until they actually access those shares. Your firm makes all the contributions to the plan directly. In general, payments fall around 7% of pay as opposed to non-ESOP plan sponsors who contribute 4% on average. Plus, these plans tend to perform well for the employees themselves. They tend to get higher rates of return than many other options with lower volatility.

ESOPs also offer intangible benefits for your employees and more than likely, there won't be any personal cost to your employees. Allowing them beneficial ownership in your company lets them share in the success of your organization, and that is always good for morale. Employee stock ownership plans give your workers a vested interest in the success of your company and help align employee interests with that of management.

Company

Offering an ESOP can be good for your operations as well. According to a survey by the ESOP Association, around 92% of companies who have created their own employee stock ownership plans think it was a smart idea – and the statistics back it up. Roughly 68% of companies who sponsor employee stock ownership plans have increased profitability, while approximately 78% have increased revenue and enhanced productivity.

ESOPs are good for your bottom line in other ways, too. While contributing stock to the employee stock ownership plan will dilute your ownership interest to some degree, you could find that you will reduce your corporate income taxes and improve your cash flow. In some cases, this will completely eliminate your tax liability.

Company Culture

Many company owners find that ESOPs are good for company culture, too. Your employees can feel a tangible benefit to receiving company stock. It lets them share in your company’s future and celebrate its growth. In turn, employees with stock ownership are more in alignment with your goals as an organization. They often work harder and are not challenged by an impending sale or other change in ownership interest. Further, ESOPs are attractive enough that they could help you attract and retain workers. Sharing in your company’s future is a significant value-add.

Current Owner(s)

Finally, employee stock ownership plans benefit the original company owners. An ESOP lets you slowly transfer ownership of your business to other people who are just as invested in its success. This helps you protect your company’s legacy as well as plan for a future that doesn’t involve your business. In this way, offering an ESOP is equal parts retirement strategy and succession plan.

Tax Advantages


There are significant tax advantages to offering an employee stock ownership plan. However, the structure of the company does influence the tax benefits received as well as how the company earnings are treated.

For S Corporations

When you have an S corporations, any contributions of stock that you make to your ESOP are tax-deductible. Likewise, any cash contributions that you make to the employee stock ownership plan are also tax-deductible. It doesn’t matter whether you are contributing that cash to build up the plan’s cash reserves or to buy shares from existing shareholders. The money you use to repay the funds you borrowed to purchase shares for the ESOP are tax-deductible as well.

Further, ESOPs can be extremely tax efficient when you have an S corp. Any income generated by the shares held in trust by the ESOP is not taxable.

For C Corporations

Contributions of stock that you make to your ESOP are also tax-deductible if you have a C corp. Further, companies structured as C corporations can deduct cash contributions to the ESOP as well. Like S corps, it does not matter whether those cash contributions will go to buy shares or build up the ESOP trust’s cash reserves. Also, like S corporations, the ESOP can take out a loan to purchase stock for the ESOP, and the contributions you use to repay that sum are tax-deductible. However, there is an essential difference with regard to taxation. With C corps, if the ESOP has 30% or more ownership in the company, the shareholders who sold shares can get a deferral on their capital gains tax through a 1042 rollover into a qualified replacement property. 

For S Corp ESOP For C Corp ESOP
  • Contributions of stock to the ESOP are tax deductible.
  • Cash contributions to the ESOP, whether it's used to buy shares from current owners or build cash, are tax deductible.
  • Contributions used to repay the loan the ESOP used to buy company shares are tax deductible.
  • Not subject to federal and most state income tax on the % owned by the ESOP.
  • Contributions of stock to the ESOP are tax deductible.
  • Cash contributions to the ESOP, whether it's used to buy shares from current owners or build cash, are tax deductible.
  • Contributions used to repay the loan the ESOP used to buy company shares are tax deductible. 
  • The earnings from the company are subject to income tax at the entity level.

 

For the employees participating in the ESOP, and for owners selling their shares to the ESOP, there are also specific tax implications and benefits.

For Employees

When you offer an ESOP, your employees will enjoy their own tax benefits. Most notably, they will not have to pay tax on any contributions made on their behalves.

If there is a separation of employment, your employees will have the option to roll that distribution over into another qualified retirement plan, like an IRA.

However, if the employee is taking a cash distribution, the amount they receive from their disbursement would be taxed as ordinary income as opposed to capital gains. And, if the employee is younger than the normal retirement age, he or she would have to pay a 10% penalty on the income tax portion of the distribution.

For Sellers

ESOPs offer one benefit that is unique to sellers. As a seller, you can defer the capital gain from your C corp stock by selling your shares to the employee stock ownership plan then investing your proceeds via a 1042 rollover. Alternatively, if you sell the shares, you can take the cash disbursement and pay gains on the sale.

For Employees For Sellers
  • Do not have to pay tax on any contributions made on their behalves.
  • Upon separation of employment, have the option to roll distribution over into another qualified retirement plan, like an IRA.
  • In a cash distribution, the amount they receive from their disbursement would be taxed as ordinary income.
  • 10% penalty on the income tax portion of the distribution if employee is under normal retirement age.
  • Can defer the capital gain from the sale of their C-corp stock to the ESOP via a 1042 rollover.
  • Sellers can take the cash disbursement and pay gains on the sale.

 

Briefcase_Laptop_Screen

Example: Using an ESOP to Defer Paying Capital Gains Tax

If you were going to use an ESOP to defer paying capital gains tax and your company is structured as a C corp, here is what a tax-deferred sale to an ESOP would look like (known as a 1042 rollover) compared to a taxable sale at a 30% tax rate.

Read more about the 1042 rollover election here.

 

This strategy only defers taxes, however, you can leverage the 1042 rollover for estate planning purposes which would allow you to pass on the assets to heirs without a tax burden. However, you as the seller would not have access to the cash disbursement.

 
 

1042 Rollover (Tax Deferred)

Taxable Sale at 30% Tax Rate

Gross purchase price

$3,000,000

$3,000,000

Tax

$0

$900,000

Net to Seller

$3,000,000

$2,100,000

Seller's Extra Cash

$900,000

$0

Potential Disadvantages


While ESOPs offer many potential advantages, they may also have drawbacks depending on your unique situation. It is vital that you speak with a financial advisor who has your best interests at heart so that you can carefully evaluate whether an employee stock ownership plan is right for your company.

Expense

First, consider the expense. Employee stock ownership plans can be expensive to establish, and they cost money to maintain. Setting up an ESOP is not inexpensive.  Depending on circumstances and complexity, transaction costs could exceed $100,000 when you account for a team that includes financial advisors and attorneys with deep ESOP expertise.  

Annual costs can be expensive as well. These costs include an appraisal, trustee fees and participant administration. These costs vary based on size and complexity, but can start around $25,000 per year – but that is a deductible expense that can be paid by the ESOP or your company.

To put these figures in perspective, selling a business to a third party is typically much higher than any of those costs combined. Brokerage fees, legal expenses, and accounting fees often add up to $300,000 and can be much more depending on your individual circumstances. 

Further, the stock you sell to your ESOP may not warrant the same price it would have received in open market. You may receive less than if you have taken your company public or sold the shares privately. If your company is not public, the value of those shares will have to be determined by an independent appraiser– and, for better or worse, that could mean that the stock price is different from you expected.

key in handParticipation

Just like a 401k, an ESOP plan can contain qualifications, however, a company cannot discriminate against specific employees. The plan document would dictate eligibility for individual participation.

Talk to your financial adviser to understand how an employee stock ownership plan would work for you.

Cash Flow & Liquidity

You should also understand your cash flow and liquidity needs if you offer an ESOP.

You will need to have enough cash flow to make the payments on the transaction debt and fund future repurchase obligations when employees leave. It's important to understand what these cash flow needs will be so that you can plan accordingly.

Fiduciary Liability

ESOPs introduce the issue of fiduciary liability as well. The way employee stock ownership plans are structured require the appointment of trustees. These individuals are considered fiduciaries, which means that they could be held liable if they participate in transactions that could be deemed improper.

Ongoing Administration

In addition to annual costs, employee stock ownership plans require continuing administration. Someone needs to manage its activities, promote the program to employees, and communicate how things are going. There are also tax issues unique to ESOPs, and the IRS may verify that your employee stock ownership plan complies with applicable requirements. These are designed to make sure that the ESOP benefits all participants instead of a select few. Make sure that you understand the obligations that an ESOP presents before you attempt to establish one.

Financing Your ESOP 


There are three basic financing options for an employee stock ownership plan. Each one has its own benefits and disadvantages, but they all allow you to transfer ownership to your employees in full or in part. The type of financing you choose will influence plan administration and participants.

The three financing options for an employee stock ownership plan are:

Non-Leveraged ESOP

Non-leveraged ESOPs are employee stock ownership plans that don't have any debt related to the stock purchase. The sponsoring company contributes newly issued stock or cash to the ESOP, which in turn is used to buy shares from the selling shareholder. This structure tends to most beneficial when the owner wants to be bought out from the company over time. Non-leveraged ESOPs can work well in situations where you want to reward employees for their service over time as opposed to giving them shares on a one-off basis.

Leveraged ESOP

When you take out a loan to buy company shares to fund the employee stock ownership plan, you have a leveraged ESOP. In this circumstance, the company would make annual tax-deductible contributions to the employee stock ownership plan, which are then used to repay the money borrowed. Leveraged ESOPs are a good option when the owner wants to be bought out all at once, or if a large volume of shares are purchased all at once (in the case of buying out a founding member of the company).

Issuance ESOP

The least common ESOP, an issuance ESOP, uses financing to acquire newly issued shares from the employer sponsor. The shares are only allocated to each plan participant’s account as the ESOP repays the loan. In the repayment period, the newly issued shares for the ESOP are held in a suspense account. Issuance ESOPs are used much less often than leveraged or non-leveraged employee stock ownership plans, but they do have important advantages. Many companies choose to offer an issuance ESOP when they want to purchase capital goods or acquire another company while enjoying tax-advantaged financing.

The ESOP Transaction Process


Before you make any decisions, you will need to have an understanding of the business value of your company and an idea of whether you will need bank financing to set it up (and whether that funding is available). You will also need to review your goals. An ESOP may be the perfect exit plan for you, but there might be many factors to consider.

puzzle light esop1. Get Educated

Start by educating yourself about the minimum requirements for creating an employee stock ownership plan at your company and reviewing the options available to you. Identifying the objectives of all parties involved—and the impact of a transaction to each one—is a critical step to understanding what is right for you and your company. An ESOP expert can help you consider all of the financial, tax, and employee issues that will accompany the transaction—now and in the future. 

2. Feasibility Study

You may also want to conduct a feasibility study to evaluate possible scenarios and make an informed decision. Think of offering an ESOP as a normal mergers and acquisitions transaction and evaluate the impact that providing such a plan will have on your business. In addition, to get an idea regarding the value of the company, it may make sure you have a reasonable idea regarding what your company is worth. The standard of value is fair market value.

3. Trustee Selection

The trustee is the individual (or group of individuals or institution) that maintains oversight over the plan assets—and has the fiduciary responsibility to act in the best interest of the plan participants.  Think about who could be named as trustee of your ESOP. This individual would be appointed directly by your company’s board and will be in charge of hiring the valuation firm, being engaged in the valuation process, managing the assets of the ESOP trust, and following plan documentation. As an on-going duty, trustees have the responsibility of establishing the annual ESOP stock price, which makes selection of the valuation firm a critical part of the process. The ability to perform due diligence and reevaluate at regular intervals the firm conducting the valuation necessitates the selection of an individual (or institution) that is extremely, knowledgeable in ESOP governance. 

4. Term Negotiations

The buyer or the seller will put together a term sheet and this sets the stage for a series of negotiations. This phase of the process can be long and arduous and includes issues that need to be resolved such as price,  seller and bank financing, stock appreciation rights (SAR), and warrants. The goal of the negotiations is to move as quickly as possible to an agreed upon closing date--and ultimately closing the deal. 

5. Ongoing Plan Administration

Once the deal is closed, there are a number of elements that need to occur on an ongoing basis per the ESOP plan documentation and laws governing ESOPs:

A. Annual contributions. The sponsoring company will need to make an annual contribution to the ESOP and, in the case of a leveraged employee stock ownership plan, the ESOP will need to use those contributions to repay the mirror loan. In turn, the sponsoring company repays its obligation to the lender. Employees are vested according to the schedule established by the employee stock ownership plan.

B. The ESOP will require an annual valuation.  With most ESOPs, the shares of the sponsoring company are often closely held. Unlike a public stock, the value of the shares is not established, and the company’s stock will need to be valued by an independent appraiser or valuation expert. The expert will be charged with setting a fair market value for the shares in the company. The valuation is conducted using the IRS's standard of value of Fair Market Value, and the trustee sets the share price based on the recommendation of the valuation expert. 

C. Plan participant communication. ESOP participants are entitled to the same information that ERISA entitles participants of other qualified benefit plans such as a summary plan description, annual statement, plan documents, etc. In many cases participants must request this documentation (and it must be provided), but best practices in ESOP plan administration suggest being proactive and at least providing an annual statement of the participants' account statuses and balances.  

In addition to the plan administration requirements, many companies like to put together an ESOP committee to promote the employee stock ownership plan within the company and to answer any questions employees may have about the program. 

Next Steps


If setting up an ESOP sounds like something that could work for your company, take the time to speak with an experienced professional who can walk you through the process. Talking with an advisor takes away the guesswork and helps you get the information you need to make an informed decision about your company’s future.