5 Reasons Your Business Might or Might Not Need An ESOP
Is an Employee Stock Ownership Plan Right for My Business?
An exploration of all of a business owner’s exit options would not be complete without considering an Employee Stock Ownership Plan, or ESOP.
To be clear, an ESOP is not a perfect fit for every business. According to a March 2021 article published on the National Center for Employee Ownership, there are only 6,501 ESOPs in the US, representing only one-tenth of one percent of all US companies that employ more than one person. However, according to a 2013 State of Owner Readiness Report commissioned by the Exit Planning Institute, about 3% of all business owners consider an ESOP as their preferred exit option.
The ESOP path is particularly appealing to those who wish to transfer their companies to known entities, perpetuate their current mission or culture, and keep their companies in their communities. In an attempt to provide a balanced article here, the following are some of the top reasons to consider an ESOP along with a few of the top reasons an ESOP may not be right for your business.
1. ESOPs transfer wealth to the people who helped build the company. Most business owners would say that their most valuable asset is their employees. ESOPs, therefore, offer an opportunity to transfer wealth to the business’s most valuable asset - a highly competitive benefit in a highly competitive job market.
2. ESOPs motivate employees. Motivated and engaged employees are much more productive. An ESOP provides an opportunity for the employees to be true owners of the business which changes the perspective of their role as well as the future of the company. Studies show that ESOP companies have a higher return on assets, a higher total shareholder return, and a higher employee retention rate compared to non-ESOP companies.
3. ESOPs allow the current owner to stay involved. Not only does an ESOP reward current employees and management by providing ownership in the company, it also typically allows the owner to stay involved in the business post-transaction, so the owner can continue their long relationship with employees, vendors, and customers. Stated another way, it retains the business owner’s sense of belonging.
4. An ESOP is a ready buyer of company shares. When a business owner decides to exit the business, finding an appropriate buyer can be a real challenge and can take years. An ESOP is a willing and ready buyer which can provide business owners flexibility in succession planning - as well as peace of mind that their employees’ jobs will not be displaced due to a sale.
5. The tax implications of establishing an ESOP are significant. It provides current owners with a vehicle to sell their current stock and avoid capital gains - which means more cash in the owners’ pocket. Whether the business is an S-Corp or a C-Corp, the tax advantages are significant. For example, an S-corp that is 100% owned by an ESOP has no income tax. (Yep, I said that!) For a C-Corp, contributions of profits to the ESOP are tax-deductible, saving the company significant tax dollars while still transferring that wealth to owners. Again, a win-win for employees and the company. Of course, always consult your tax professional for your specific situation.
1. ESOPs can be complicated to navigate. An ESOP is not for the Do-It-Yourself individuals. The business owner and employees will need outside help which can be costly. And, the business has to be able to borrow or find investors to pay the owner at closing. Many times, the owner carries a long-term note from the company, even though he’s typically no longer involved in the day-to-day operations of the business.
2. An outside strategic or financial buyer may be willing to offer a substantial premium. If price is the primary concern for an owner, an ESOP may be the wrong choice - especially if there may be a synergistic buyer who would offer a premium for the business.
3. ESOPs may be too expensive for very small companies. ESOPs typically cost $80,000 or more to set up, even for very small companies. For very small businesses these costs may be greater than potential tax benefits. To be clear, once set up, the cost to maintain an ESOP, with all of the required paperwork and filings, will exceed $30,000 annually as well.
4. ESOPs require successor management to be in place. If the owner is the key manager, they will need to have a capable successor in place to obtain an outside loan as well as to help assure that the company will be able to pay for the plan over time. If there is no succession plan already in place, an ESOP may not be the right option.
5. ESOPs require the company to be profitable enough to afford the contributions. When an ESOP is buying out an owner, the cost is a non-productive expense, so the business must assess whether it has the available earnings for this. ESOPs are not usually good choices for struggling companies.
Frankly, I could go on and on on the advantages and disadvantages of ESOPs. However, for simplicity, I typically boil it down to one simple question: What’s more important - the price or the people. Although it’s far more complicated than that, the answer to that one question will tell any business owner whether they should even consider an Employee Stock Ownership Plan.
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ABOUT THE AUTHOR
Tom Bronson is the founder and President of Mastery Partners, a company that helps business owners maximize business value, design exit strategy, and transition their business on their terms. Mastery utilizes proven techniques and strategies that dramatically improve business value that was developed during Tom’s career 100 business transactions as either a business buyer or seller. As a business owner himself, he has been in your situation a hundred times, and he knows what it takes to craft the right strategy. Bronson is passionate about helping business owners and has the experience to do it. Want to chat more or think Tom can help you? Reach out at firstname.lastname@example.org or check out his book, Maximize Business Value, Begin with The Exit in Mind (2020).
Mastery Partners, where our mission is to equip business owners to Maximize Business Value so they can transition their business on their terms. Our mission was born from the lessons we’ve learned from over 100 business transactions, which fuels our desire to share our experiences and wisdom so you can succeed.