The Power Move: Discover Why Savvy Business Owners Are Opting for ESOPs to Redefine Their Exit Journey
The ESOP is an exit strategy you may not have considered. An Employee Stock Ownership Plan (ESOP) is a type of retirement plan that enables employees to become partial owners of the company they work for by acquiring shares of the company's stock.
Now, why should you care if you’re a small business owner and are planning to exit your company?
Because an ESOP can serve as a succession or exit strategy for your business. The ESOP allows you to exit the business all at once or gradually, often providing continuity for your company and employees.
ESOPs are complex and are best suited for companies with more than 20 employees and revenue of $5 million or more. However, as a business owner, ESOPs have significant advantages and, like any other exit approach, there are also disadvantages.
Interested? Read on for the basics of an ESOP as it pertains to small business owners along with a list of pros and cons for you, your company, and employees.
How An ESOP Works
ESOPs are nothing new. Various forms of employee stock ownership have been around since 1956. The legal and tax framework for ESOPs as we know them today was created in 1974 as part of the Employee Retirement Income Security Act (ERISA). You can read more about the history of ESOPs at the ESOP Marketplace.com.
ESOPs are not just for large companies. There are over 3,400 ESOP companies with less than 100 participants. In total, 6,232 companies have ESOPs in the U.S. according to the National Center for Employee Ownership.
Briefly, here's how an ESOP works as an exit strategy:
Your company would establish a trust fund and contribute new shares of its own stock or cash (which can be borrowed) to buy your ownership.
The trust is established on behalf of the employees who become participants in the ESOP. The employees do not buy the shares; rather, they receive an allocation of shares based on their compensation or other factors.
Each year, the ESOP allocates a portion of the company's shares to individual employee accounts within the trust. The allocation is usually based on factors such as salary or years of service. Employees typically become vested in their ESOP accounts over a period of time. Vesting refers to the period an employee needs to work for the company before they have full ownership of the allocated shares.
When employees leave the company or retire, they can receive the value of their vested ESOP shares. The company may buy back the shares, or the ESOP trust may sell the shares back to the company.
The company still needs a management structure, but employees may participate in the decision-making processes of the company. This is done through an ESOP committee or other means, depending on the structure of the ESOP.
Advantages and Disadvantages
For You as the Business Owner
• ESOPs provide a structured succession plan, allowing you to gradually transition out of your company while ensuring continuity and stability.
• ESOPs offer various tax advantages for both the selling business owner and the company. This includes tax-deductible contributions and potential capital gains tax deferral.
• The business owner can achieve liquidity by selling their shares to the ESOP, providing a way to exit the business and realize value without immediately selling to an external party.
• ESOPs can be a powerful tool for retaining key employees, as they become invested in the success of the company and may see improved retirement benefits. Furthermore, you can defer capital gains tax on the sale to an ESOP if you reinvest the proceeds in qualified replacement property (such as stocks and bonds of domestic operating corporations).
• You have flexibility in determining your exit timeline. You can choose to sell all your shares at once or gradually over time.
• ESOPs often help preserve your company culture and values because employees have a stake in maintaining the business's success and identity.
• ESOPs can enhance employee engagement and motivation as employees become partial owners of the company.
• On the other hand, an ESOP has some disadvantages for you as well. Chief among them are the complexity and cost to set one up and maintain it. There are administrative expenses, legal fees, and the need for ongoing communication and education.
• Also, the market for ESOP shares is limited to your company's employees. As a result, the lack of a broader market may mean you’ll sell for a lower price
For the Company
• Companies can make tax-deductible contributions to the ESOP trust, which is used to buy shares. This provides a way for the company to fund the ESOP while obtaining a tax benefit.
• If the ESOP borrows money from a bank or another lender to purchase company shares(this is called a leveraged ESOP), the company can deduct the interest on the loan used to fund the ESOP.
• C corporations that convert to S corporations in conjunction with establishing an ESOP can potentially reduce or eliminate federal and state income taxes. This is due to the deferral or elimination of taxes on built-in gains.
• Some states offer tax incentives or exemptions for ESOP-owned companies, providing an additional layer of potential tax savings.
For Employees
ESOPs offer advantages to employees as well. For example:
• Employees participating in an ESOP can accumulate retirement savings on a tax-deferred basis. Contributions made by the company to the ESOP on behalf of employees are not currently taxed.
• Employees who retire or leave the company and receive a distribution from the ESOP can roll over the proceeds into an Individual Retirement Account (IRA) or another qualified retirement plan without incurring immediate tax liability.
• Employees can defer taxation on the capital gains realized from the sale of ESOP shares until they sell the shares outside the ESOP.
• Employees reaching a certain age or service threshold may have the option to diversify a portion of their ESOP holdings without triggering immediate tax consequences.
Businesses That Might Be Able to Use an ESOP Exit Strategy
There is no one business type that can use an ESOP as an exit strategy. The National Center for Employee Ownership (NCUE) points out that 21% of ESOPs are professional service/scientific/technical companies. Manufacturing businesses make up 20% of ESOPs followed by construction, finance and wholesale and retail companies.
In general, your company may be a good fit for an ESOP if it’s:
• Mature and Profitable: ESOPs work well for established businesses with a track record of profitability. This provides employees with confidence in the company's stability and potential for future growth.
• Has Stable Cash Flow: Businesses with consistent and predictable cash flow are ideal for ESOPs. This stability can help ensure that employees receive consistent benefits through their ownership in the company.
• A Culture-Driven Company: If your company has a strong and positive corporate culture, an ESOP may be a good fit. Employees who already value their workplace culture are more likely to embrace the idea of ownership and contribute to the company's success.
• A Businesses That Can Take Advantage of Tax Benefits: ESOP transactions can be structured in a way that provides tax advantages for both the selling owner and the company.
• Large Enough: Remember, companies with at least 20 employees and $5 million in revenue is a minimum size due to the complexity and cost of an ESOP.
Summary
While ESOPs can be a great option for many businesses, they are not a one-size-fits-all solution. You’ll need to consult with financial advisors, legal experts, and professionals experienced in ESOP transactions to determine if it's the right exit strategy for your business.
If you want to know more about how an ESOP might help you exit your company, Moss Adams, a professional services firm, has published several excellent articles. Or you can contact me for a complimentary Get Acquainted session. I worked on my first ESOP in 1977!