An Intro to ESOPs: Preserving Company Mission, Benefiting Employees & More
Recently, there has been a rising tide of interest in Employee Stock Ownership Plans (ESOPs) and the Federal Government is doing its part.
The Main Street Employee Ownership Act was signed into law last summer and will help smaller employers find financing. This is a welcomed change for mission-oriented companies. Larger middle market companies have had access to ESOP financing for some time. Smaller companies have struggled to finance ESOPs, but now have better access to US Small Business Administration financing.
While ESOPs aren’t new and there are many benefits, they’re also complicated. ESOP professionals love to talk about complexity and cite obscure sections of law. We’re going to skip that. Your lawyers and financial advisors can help you understand the details. We want to deal with just the overall risks and advantages without getting hung up on the minutia. Here are the most important things you need to know about ESOPs.
What is an ESOP?
In its simplest explanation, an ESOP is a tax-qualified, defined contribution retirement plan similar to a 401 (k) or profit sharing plan.
The term “tax-qualified” refers to a special tax treatment received by the company and its employees. An ESOP is similar to a profit sharing plan that invests in company stock instead of marketable securities. When offering an ESOP, the company receives tax advantages and, in some circumstances, can eliminate federal and state income taxes.
The retirement benefits aren’t determined, but depend on contributions made to the ESOP and the performance of the company. Employees’ ESOP balances grow on a tax-free basis. Employees only pay taxes if they decide to take a distribution and do not rollover funds to an IRA or other qualified plan.
Common Reasons to Consider an ESOP
You’re considering a sale of the business
You want the business to be independent
You want to sell without risking the loss of mission & culture
You would like to reward and incentivize your employees
The sellers benefit because an ESOP can preserve the company’s mission, vision, culture and independence while also rewarding company management and employees. An ESOP can pay full value to selling owners and possibly postpone or avoid capital gains. If a seller would like to find a road to owner liquidity while remaining active in the business, an ESOP is one advantageous strategy.
A company can benefit in a few key ways. First, from a cost-savings perspective, an ESOP can reduce or potentially eliminate future income tax liability. Second, ESOPs can improve employee retention and also attract key employee recruits. From a performance perspective, research has shown that ESOP companies outperform their peers. An ESOP can also provide a strategic advantage by investing income tax savings into business expansion or pay down debt.
ESOPs reward company management and employees by creating a tangible link between company performance and employees’ pocketbooks. The risk of a layoff following a sale to a competitor is eliminated, so employee retention is strengthened. Creating a sense of ownership in the employees also enhances employee morale.
Although an ESOP has many advantages, there are also a few concerns. First, if an employee leaves or is terminated, their stock must be repurchased—referred to as repurchase liability. The purchase can be termed out over time, other than in cases of death or disability. After ten years, there are possible increases in the repurchase liability due to the diversification rules. These risks are managed by having the administrator conduct a repurchase liability study so you can plan accordingly. For most companies, the tax savings provide the means to meet these obligations.
Also, like any employee retirement plan, ESOPs are subject to government reporting as well as possible Department of Labor Audits. There are additional annual administrative expenses. These expenses, typically in the area of $30,000 to $60,000 per year for most middle market companies, take care of annual administration, ESOP valuation, and advisors, in addition to government reporting.
If a company decides to sell, recapitalize, or merge, employees have limited rights other than to vote on the transaction. Due to the ESOP structure, employees have no additional role in management. The company continues to be managed by the Board of Directors and additional or future Board members are typically chosen by the Governance Committee of the Board. The Trustee of the ESOP, usually a third party, does have an obligation to maximize the value for the beneficiaries, the employees. This could result in a sale of the business to a party who changes the business in a way that is adverse to existing stakeholders.
An ESOP won’t solve all your problems, but it can provide shareholder liquidity, tax efficiency, and the satisfaction of knowing that you’ve successfully passed the business onto the team that helped to create your company. If you’re considering an ESOP, take our free assessment to find out whether or not it’s right for you and contact us for a free consult.
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