ESOPs: Understanding Employee Stock Ownership Plans and Your Business Legacy

As a business owner, planning for the future of your company is as critical as managing its day-to-day operations. One of the most significant decisions you’ll face is how to ensure a smooth and successful transition when you’re ready to step back from your role. Integrating your business succession plan into your comprehensive financial strategy can safeguard your legacy, provide for your retirement, and take care of the employees who have helped build your success. One option that stands out in this context is an Employee Stock Ownership Plan (ESOP).

An ESOP allows you to sell your business to your employees, offering a path that can align with your financial goals while ensuring the continuity of your business. But what exactly is an ESOP, and how can it fit into a business owner’s financial strategy? We collaborated with Rick Jaye, Managing Director of Business Transition Advisors (BTA) and an ESOP expert to help explore the basics.

What is an ESOP?

An Employee Stock Ownership Plan (ESOP) is a retirement plan that gives employees ownership interest in the company they work for. Essentially, an ESOP allows employees to acquire shares in the company, making them partial owners. This type of plan is different from traditional retirement plans like 401(k)s because it involves actual ownership of the company’s stock. And for you, the owner, you can get immediate liquidity, defer taxes, retain company control if desired, and protect the legacy of your company.

Here’s a basic overview, according to NCEO, the National Center for Employee Ownership.

• Business owners sell some or all of their shares to an ESOP trust, which owns those shares on behalf of employees.
• ESOP transactions usually involve a loan. The company can take out a loan and then reloan the funds to the ESOP trust. The company makes contributions to the trust, which the trust uses to repay the loan. Sometimes the person selling the shares provides the loan. Almost all ESOPs are completely company funded, meaning employees pay nothing.
• As the loan is repaid, shares become available to allocate to employee accounts. The allocations must be made on a non-discriminatory basis, like payscale or a more level formula. With limited exceptions, all employees participate in the plan.
• The company administers the plan in accordance with federal laws and regulations that govern contribution and allocation limits, vesting, benefit distributions, and diversification.

NCEO says ESOP companies often have ownership cultures that encourage employees to “think and act like owners.” Research shows such companies are more productive, faster growing, more profitable, have less turnover, and generate more wealth.

Who is an Ideal ESOP Candidate?

ESOPs are not a one-size-fits-all solution. They are typically most beneficial for:

• Business Owners Planning for Succession: Owners looking to sell their business or transition out of daily operations might consider an ESOP as a way to ensure the company remains in good hands while rewarding loyal employees.
• Companies with Stable Cash Flow: Since an ESOP involves buying out the current owner’s shares, the company needs a steady cash flow to handle the financial obligations associated with setting up and maintaining the ESOP.
• Medium to Large Private Companies: ESOPs are more common in private companies with 20 or more employees, where there’s enough profit and stock value to make the plan worthwhile.

What are Key ESOP Benefits?

According to NCEO’s statistics, ESOPs offer several compelling benefits for both business owners and employees:

• Succession Planning: For business owners, an ESOP can provide a smooth transition of ownership, often with tax advantages. ESOP companies are 25% more likely to stay in business.
• Employee Motivation and Retention: ESOP company employees earn 5-12% more in wages and have 2.5x greater retirement account balances on average motivated and committed to the business’s success. This ownership stake can also be a powerful retention tool.
• Company Growth: On average, productivity improves by 4-5% in the year an ESOP is adopted, with 25% higher job growth over 10 years than comparable non-ESOP companies.
• Tax Advantages: Companies can often deduct contributions to the ESOP, and employees can defer taxes on the stock they receive until they sell it.
• Business Continuity: An ESOP can help ensure the business continues to operate smoothly after the original owner steps down, preserving the company’s legacy.

What are Key ESOP Risks?

Despite their advantages, ESOPs come with certain risks that need to be carefully considered:

• Complexity and Cost: Setting up and maintaining an ESOP can be complex and expensive. Companies need to invest in ongoing administration, legal advice, and annual valuations.
• Financial Strain: If not managed carefully, the cost of buying out the owner’s shares can strain the company’s cash flow, potentially affecting its financial health.
• Employee Discontent: If the company’s stock performs poorly, employees’ retirement funds may suffer, leading to dissatisfaction or turnover.
• Dilution of Ownership: The original owner’s shares are diluted, which may reduce their control over the company as more employees become shareholders.

Having the right team in place is crucial to a successful ESOP. When done right, an ESOP can lead to big success stories.

ESOP Case Studies

Here are two hypothetical ESOP case studies from Rick and his team at Business Transition Advisors.

Concrete Construction

Background

• Specialized C-8 concrete contractor making high quality foundations home builders
• S-Corp with 4 owners and 530 employees
• Valued at $28 million.

Goal

• The owners want to exit the business in 7 years
• They want to reduce or eliminate corporate taxes, if possible.

Solution

• Owners sell 100% of their stock to an ESOP
• In exchange for selling their stock sellers will receive cash and seller notes
• $1.5 million down payment from Company cash to use towards paying down the shareholder Accumulated Adjustment Account balances.
• Balance of AAA and stock sale will be funded by seller notes.
• $1.5 million down payment is made from company cash with the remaining stock sale funded by seller notes.

Benefit to the client

• Business is now transitioned to the employees who helped build the company.
• Owners will receive payments on notes totaling $26.5 million over 15 years with warrants estimated at $14.6 million at the end of the note period.
• As a 100% S Corp. ESOP owned company, 100% of future profit will not be taxed from that point forward.
• Total estimated corporate tax savings over the next 15 years of more than $52 million.

Engineering Firm

Background

• Department of Defense engineering consulting firm
• An S-Corp with 1 owner and 30 employees
• Valued at $9 million.

Goal

• Create an effective estate planning strategy
• Owner wants to exit in 10 years
• Transition company to employees as a way to retain and motivate.
• Retain key employees who came from another, less transparent ESOP company.

Solution

• Owner sells 100% of his stock to an ESOP.
• He receives $1.5 million cash at closing and $7.5 million seller notes plus warrants.
• Employees will be granted stock annually over a period at zero out of pocket cost to them.
• As employees increase revenue, increase margin, reduce waste and costs, improve service, stock value increases driving a higher retirement benefit.

Benefit to the client

• Provides a clear path to liquidity for owner while protecting the legacy of what was initially built to offer friends and family a concept of ownership.
• Helping further enhance and increase retirement benefits for long-term employees who help drive company value.
• Conversion of annual K-1 income subject to ordinary income taxes to long term capital gains tax treatment with upside tied to the warrant allocation.
• Protecting key employees and family in the business with jobs after the sale and additional benefits through ESOP participation and SARS grants.
• Roth conversion of early granted shares to selling shareholder, family of shareholder, and key employees, saving potentially $100,000’s in taxes at retirement.

Hypothetical example(s) are for illustrative purposes only and are not intended to represent the past or future performance of any specific investment for actual clients.

Frequently Asked ESOP Questions

How is an ESOP different from a 401(k)?

While both are retirement plans, an ESOP involves ownership of company stock, whereas a 401(k) typically involves a broader range of investment options like mutual funds.

Can ESOP shares be sold?

Yes, but usually only when an employee leaves the company or retires. The company typically buys back the shares at their fair market value.

How is the value of ESOP shares determined?

The value is determined by an independent valuation expert, who assesses the fair market value of the company each year.

What happens to the ESOP if the company is sold?

If the company is sold, employees are usually paid out the value of their shares, either in cash or in shares of the acquiring company.

How Does an ESOP Fit into a Business Owner’s Comprehensive Wealth Management Plan?

For business owners, an ESOP can be a strategic part of a broader financial and wealth management plan. It offers a way to transition out of the business while rewarding employees and potentially gaining significant tax benefits. However, it’s important to work with financial and legal advisors to ensure that the ESOP is structured in a way that aligns with the owner’s overall financial goals, such as securing retirement income, preserving the company’s legacy, and managing tax implications.

If it’s right for you, an ESOP can be a powerful tool to help ensure a smooth transition of ownership, while also providing valuable benefits to employees. However, it’s crucial to weigh the benefits against the potential risks and complexities, and to incorporate the ESOP into a broader financial strategy that aligns with your long-term goals. Find out more about How We Work!