If you’ve never heard of the term “ESOP,” you’re not alone. ESOP stands for “Employee Stock Ownership Plan,” and it’s not very well known. In fact, ESOPs only account for 0.88% of all companies with 20 or more employees. However, they can be a great option for tightly held companies looking to reward hardworking employees who’ve helped build the business over the years or owners who want to sell but still maintain a path of ownership for family successors.
ESOPS are an employee benefit plan that give workers ownership interest in the company in the form of shares of stock. Business owners sell some or all their shares to an ESOP trust, which owns those shares on behalf of employees. It’s important to note that ESOPs are tax-qualified retirement plans that primarily invest in employer securities. In fact, Congress structured the tax code to specifically encourage ESOPs. They work similarly to defined contribution plans, like a 401(k), where each participant (employee) has an account. The Internal Revenue Service (IRS) and the Department of Labor (DOL) regulate ESOPs like 401(k) Plans. In an ideal situation, an ESOP can pave a way to sell a business that benefits the company, employees, and the selling business owners.
There are different types of ESOPs, with the most common being leveraged or non-leveraged.
- A non-leveraged transaction ESOP doesn’t utilize borrowed funds to acquire the sponsoring employer’s stock. Instead, it’s funded by contributions of cash or stock directly from the employer sponsor. These tend to be the less complicated option with fewer parties involved.
- A leveraged transaction ESOP means the sponsor company enters into a loan agreement with an outside lender. The ESOP trust would use the cash received from the sponsor company to purchase the sponsor company stock from the selling shareholder(s). While leveraged financing can be more complicated than non-leveraged, but it may provide more flexibility in terms of business objectives and tax planning for the company.
When considering if an ESOP is right for your company, it is important to weigh in the pros and cons. Here are a few high-level points to consider:
Potential Advantages
- The Owner of the company keeps control if they maintain 50% plus 1 share post-transaction.
- In most cases, management remains the same following an ESOP transaction making it a smoother transition for employees.
- The Transaction Costs are usually less than those incurred when selling to an outside party. This includes the deferral of capital gains tax from the sale of stock.
- ESOPs are required to include all employees that meet minimum service requirements, allowing younger and lower income employees to reap the benefits of a retirement plan they might miss out on defined contribution plans.
- ESOPs supports shared success. Research shows that employee-owned businesses were 6.2 times less likely to lay off workers than conventionally owned companies. A more recent study by the National Center for Employee Ownership (NCEO) found that companies who utilized ESOPs provided exceptional resiliency and financial security in the face of pandemic-driven economic challenges.
Potential Disadvantages
- Required annual valuation for private companies. This will be a regulated environment which involves DOL and IRS oversight.
- Must plan for and fund future repurchases of stock from employees, which can be significant depending on demographics.
- The accounting involved is complex and may be counterintuitive.
- May encounter unique fiduciary issues. If transitioning to an ESOP, it’ll be necessary to find certain insurance policies that properly cover the exposures. The policies that would be primarily affected would be fiduciary liability and directors’ and officers’ liability.
- Employee participants take on risk if the company underperforms, thus negatively impacting their shares. Also, there may be less retirement investment diversification.
These are just a few points to consider. To fully understand ESOPs, please reach out to a Marsh McLennan Agency advisor.
