What is an ESOP?

An Employee Stock Ownership Plan (ESOP) is a form of retirement plan, although the benefits go far beyond a typical 401(k) plan. ESOPs, unlike a 401(k), does not require an out-of-pocket contribution from employees. When ESOPs are created, shares of company stock are allocated to employees, allowing them to own a part of the company with no money from their paycheck. ESOPs often create more loyal employees– the more stake they have in the business, the more invested they become.

Pros

1. You can sell partial stakes in your company, rather than the full thing. Many investors are not interested in buying a partial stake, but an ESOP can buy any percentage of stock with the additional option of increasing that percentage at a later date. This gives you full control over when and what you sell.
2. Your company maintains its identity post-sale. Non-ESOP sales do not guarantee that your business will look the same, as the new owner may decide to split the company and sell it in smaller pieces. This leaves your employees more vulnerable, as their job security is at risk. An ESOP sale rewards your loyal employees for helping make your company what it is today.
3. There are opportunities for taxation deferment based on your corporate structure. If you meet certain requirements as a C corporation owner, you can indefinitely defer capital gains taxes on the ESOP sale under IRS Code Section 1042. Due to how taxes function for S corporations, a 100% ESOP-owned S corporation will have no income tax.
4. You can still be involved in your company post-sale. ESOPs are unique in the way that they give owners flexibility in exiting. Whether you want to continue working, step back into a board member role, or exit your business entirely, you can do so using an ESOP.

Cons

1. ESOPs have continual upkeep. If you want your ESOP to purchase a sufficient amount of stock, you will likely have to contribute to it more than other retirement plans. ESOP loans, while potentially helpful in garnering the amount of stock you want to allocate to employees, do not give your business much flexibility in paying it back. Additionally, private companies are responsible for repurchasing shares from former participants, so current participants have the shares they need. A buyback rate of 2 - 5% is typical. 
2. ESOPs can be expensive, even for small companies. An ESOP will cost more than $100,000 to set up, not including continual upkeep costs. Annual costs for administration, valuation, and an optional outside trustee can range from $35,000 - $65,000. 
3. ESOPs can’t pay above fair market value, unlike a motivated buyer. However, even a competitive buyer paying above FMV does not have the benefits, like tax deferral, that ESOPs include. Additionally, ESOPs don’t contain the contingencies a traditional buyer might expect.
4. ESOPs can stimulate IRS and DOL investigations. Investigations from the Internal Revenue Service and the U.S. Department of Labor can be costly if penalties are incurred, but these do not happen regularly. Engaging with legal and tax advisors to ensure your ESOP is compliant with all rules and regulations can mitigate any fines from the IRS or DOL.

Why You Should or Shouldn’t Use an ESOP

Employee Stock Ownership Plans are very useful, but they aren’t for everyone. Due to their large upfront costs and maintenance fees, small businesses likely don’t generate enough income to make the trade-off worth it. Even if your business is larger, it needs to be profitable enough to offset these costs. Your management must be capable of running the company, while keeping in mind that the employees now share ownership too. While employees won’t make day-to-day decisions like the managerial staff will, employees are often demotivated by ESOPs when it isn’t paired with more influence over the company.

Are you unsure if an ESOP is right for you? Contact an experienced advisor at Stony Hill Advisors to learn more about Employee Stock Ownership Plans and its alternatives. Want to learn more? Read last week’s blog on Avoiding Common M&A Planning Pitfalls.