A business owner who selects employee ownership as a transition strategy, a means to reward employees, solidify succession planning, etc. has several alternatives to get a company’s equity into employees’ hands. Employees can purchase stock directly. They can receive stock as a bonus. They can be granted stock options. Smaller companies can participate in a worker cooperative. Or in the right situation, equity can be conveyed by establishing an employee stock ownership plan (“ESOP”).
An ESOP is a retirement plan that looks much like a profit-sharing plan. The owner of a company sells some or all of the outstanding stock, effectively to the company’s employees. Then in subsequent years, the ESOP participants (i.e., qualified employees) receive an allocation of the company’s stock, hopefully building in quantity and value over time. These shares are held in a trust account for the benefit of the employees and valued each year. When employees retire, are able to diversify their ESOP account, or terminate their employment, they have the right to sell the stock back to the company.
As an example, Mary Jones is the owner of ABC Widgets and has received offers to buy her company from competitors and private equity groups, but is unsure of what will become of her company’s legacy and employees if she sells to these types of suitors. She is also unsure of whether she wants to sell the entire company or retain an ownership interest based on her optimism about the future. In the meantime, employee John Smith has worked in the plant maintenance department of ABC Widgets for many years and is a valued contributor to the company’s success. After much thought, Mary decides to sell 100 percent of ABC Widgets to an ESOP for a combination of cash at closing and seller financing. Mary remains at the company and participates in the ESOP with her fellow employee-owners, including John. Henceforth, ESOP participants receive annual allocations of stock that increase in per share and overall value over time. The positive trajectory of the share value is aided by the quantifiable tax benefits exclusive to ESOP companies as well as “soft” intangible benefits generated by the employee ownership culture. Eventually, both Mary and John retire, with Mary confident about the future of the company and its successor management, and John financially secure knowing his allocation of ESOP shares has appreciated considerably.
Indeed, ESOPs may enable a business owner to sell his or her Company, in whole or in part, and maintain its legacy, as opposed to selling to a private equity firm, a competitor, or some other buyer apathetic about the longstanding culture and history of the Company. As an added benefit, the Company and the selling business owner may receive tax benefits.
In general, and among many other benefits, ESOPs:
- Preserve the company legacy and culture and retain key management
- Reward the employees who helped the Company achieve its successes
- Incentivize employees to adopt and foster a widespread ownership culture
- Reduce the potential for financial distress caused by more traditional (less tax-favorable) funding methods
- Spur incremental financial growth and profitability
- Minimize declines in employee morale caused by selling to a third party
- Help recruit new talent and attract the next generation of leadership
While ESOPs provide many economic, cultural, and succession benefits, there are some challenges or “cons” associated with this ownership structure.
- Educate employees on the meaning of ownership and how ESOPs work
- Provide more transparency about the company’s financial goals and success than most closely held businesses
- ESOPs can be expensive to implement and maintain correctly
- ESOPs are subject to government oversight; therefore, it is important to seek proper advice from the onset. Fiduciary responsibility should not be taken lightly.
According to the National Center for Employee Ownership, there were nearly 6,500 ESOPs across the country as of 2019 (the most recent data available). In the right circumstances, ESOPs are a wonderful tool for rewarding employees, preserving company characteristics that may have taken years or decades to achieve, while giving the selling owner financial and operational alternatives he or she would not have in a “traditional” business sale format.
If you are a business owner considering an ESOP for your company, we are happy to discuss and brainstorm the advantages, and disadvantages with you in greater detail. Please email or call us. We look forward to helping you.