Employee stock ownership plans (ESOPs) are an attractive tool for closely-held business owners who are evaluating succession planning options. ESOPs can provide unique benefits to selling shareholders, employees and the company. Despite the potential benefits of an ESOP and their existence for over 40 years, the exit strategy is often unknown or misunderstood by business owners. For an overview of an ESOP as an ownership transition tool, see our overview article.
For those who have heard of an ESOP, it can be difficult to sift through all of the information to understand if the option may apply to your business and how an ESOP may affect the future of the business. Not only is there an ocean of information to absorb on ESOPs, but also some of the information you hear may be incorrect or misinterpreted. The following lists common ESOP myths and explains the context of each issue to help you interpret the reality of these statements.
Selling to an ESOP requires owners to give up control of the business.
What is true: An ESOP owns company stock so current owners of the company do have to give up some portion of company ownership to implement an ESOP. The ESOP may purchase shares of any one or all shareholders so the effect on current owners may be different for each owner, depending on how the stock sale is structured.
What is not true: Giving up some company ownership is not always synonymous with losing control of the business, though. First, an ESOP can own any percentage of the company stock so it is possible for existing owners to retain control through continuing to hold a majority of the shares. Second, control of company operations and control of voting matters are two different things. Ownership will govern voting rights, and a trustee will be responsible for the ESOP’s shares in most voting matters (exceptions do exist for large transactions such as mergers or liquidations which require employee participants in the ESOP to vote), but day-to-day operational control of the company remains with the management team and the Board of Directors, similar to any other corporate governance situation. See our separate article on control for more detail.
ESOP transactions place a large amount of debt on employees.
What is true: Most ESOP transactions result in the company incurring debt to finance the transaction, because essentially, the company is buying its own stock and transferring that stock to employees as part of their retirement benefit.
What is not true: The employees are not individually responsible for the debt. Ultimately, the value of the stock allocated to employees in their ESOP accounts will be affected by the debt on the company’s balance sheet, because liabilities reduce the value of equity. However, employees are allocated shares, not a direct portion of any debt. Also, employees will receive an annual statement that shows the number of shares in their account and the net value per share; they will not receive information that shows the debt the company incurred to purchase the shares, and they will never owe any money back to the company if they leave before the debt is repaid because the debt is not their individual obligation.
Small companies cannot do an ESOP.
What is true: Company size is a factor in whether an ESOP will be successful for the company. The measures that are most important in determining “size” of the company are number of employees, value of the company and annual net cashflow. Exactly what level of each of these factors is necessary for an ESOP to be feasible depends upon the level of the other factors. An ESOP does come with initial and ongoing costs so there is some size that would be small enough that the costs outweigh the ESOP benefits.
What is not true: What is “too small” to make an ESOP feasible is not as “big” as one might think. Often, having 15-20 employees may be enough for an ESOP to work so long as the value of the company being transferred to those employees can fit within certain tax limitations for employee benefit levels and it makes sense from a business perspective to provide employee benefit levels that align with the value being transferred to them. From the perspective of company value, companies worth $5 million or more may be good ESOP candidates, depending on the number of employees such that the benefit provided per employee is perceived as valuable enough to outweigh the costs of the ESOP. And from the net annual cashflow perspective, the level of cashflow necessary is not a fixed number, but rather depends on the other variables—it is likely something more than $0 since there are annual fixed costs of the ESOP, but depending on the transaction structure, tax savings may help outweigh some of the new costs so the exact cashflow needed cannot easily be generalized.
Having an ESOP limits the company’s future.
What is true: Having an ESOP owner will likely change certain aspects of the company such as performance and decisions that are made with respect to potential future transactions regarding ownership of the company.
What is not true: The changes are typically not “limiting.” If the ESOP benefit is valuable and is communicated properly to employees, it can actually increase company performance through employee productivity and loyalty (for more information on this aspect, see the National Center for Employee Ownership’s article summarizing research in this area). In addition, while the ESOP is a shareholder with voting rights, the trustee’s duty is to vote the shares in the best interest of participants’ retirement account values so the same exit opportunities remain available to the company in the future and the trustee has an obligation to explore those opportunities if they are in the best interest of participants’ accounts. Therefore, the company can still be sold to an outside party in the future or participate in any transaction that it could have prior to the ESOP; it’s just that the ESOP trustee will be a party at the table in the future.
The annual costs of an ESOP are prohibitive.
What is true: ESOPs do have costs. In the early stages, the company will incur costs to evaluate plan feasibility, hire a trustee, finance the stock purchase, value the stock and get advice from service providers (likely accountants, attorneys and potentially other consultants) on the transaction, as well as the cost for all of the legal documentation of the transaction. On an annual basis, the costs include trustee fees, plan administration, a valuation, and potentially a financial statement audit for the ESOP.
What is not true: These costs are not necessarily prohibitive, but they must be weighed with the benefits the ESOP will provide. One step that should be taken in the early stages is to estimate the costs so the company has an approximate idea of the cashflow that will be necessary to setup and operate the ESOP. Depending upon how the ESOP is structured and company performance, it is possible that tax benefits may even outweigh the costs of the ESOP over the life of the plan.
The repurchase obligation is impossible to manage so an ESOP won’t work.
What is true: The net cashflow responsibility from the company to the ESOP for the employee benefit occurs in the future, different from a 401(k) plan in which the company puts cash into the plan on a current basis. In an ESOP, the company is essentially contributing shares to employees each year, and the cash need comes in the future to repurchase those shares from employees who are due distributions from the plan. This future cash need is dependent upon the value of the stock in the future when employees leave the company so it is a matter of estimating that potential amount which is more difficult than a more predictable 401(k) contribution amount.
What is not true: The repurchase obligation is not impossible to manage though. Companies can use a number of variables to estimate the future need including employee demographics, estimated company performance and plan distribution terms. Estimates can help the company plan for years in which cash will be needed for repurchases. In addition, the repurchase obligation can be easier to manage if flexibility is built into plan terms governing distributions. For example, companies may choose to provide terms that allow for lump sum distributions if the cash is available but installments in years in which the company does not have enough cash for lump sum distributions. Another option is to contribute cash to the ESOP in good years for the company so the ESOP already has the cash available for use in a future year when stock repurchases may be higher.
As can be seen, deciphering these myths and understanding the true implications of an ESOP for your company involves many factors. Instead of getting spooked by statements you have heard, it is best to discuss the pros and cons of an ESOP with a qualified advisor to get a better understanding.