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Understanding ESOPs: How To Determine If An Employee Stock Ownership Plan Is Right For You

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An Employee Stock Ownership Plan (ESOP) offer compelling advantages for business owners, companies and their employees. Out of all the business planning options out there, they stand out because of their flexibility.

This second installment of our 4-part primer looks at some of the options, benefits, and possibilities associated with ESOPs, and the questions to ask when considering if an ESOP is right for you and your company. In Part 1, we looked at ESOP Basics. Part 3 looks at ESOP’s tax benefits. Part 4 discusses how many shares the owner should sell to the ESOP.

ESOPs Can Deliver Many Options, Benefits And Possibilities

They can:

  • Lower transaction costs.
  • Facilitate cash flow in a management-led purchase of the company.
  • Provide an opportunity to reinvest the sale proceeds while deferring capital gains.
  • Deliver a ready-made market for stock.
  • Acquire shares with pre-tax cash flow.
  • Buy out a dissident or unhappy shareholder.
  • Reduce or eliminate the company’s tax liability.
  • Provide liquidity for heirs who wish to continue in the family business.
  • Establish minority discounts on family-held stock for estate planning purposes.
  • Attract financing at about 85% of the cost of conventional financing.
  • Diversify assets through minority shareholding.
  • Allow the selling owner to remain involved during the purchase, lowering the seller’s risk.
  • Attract minority-subordinated equity investors in a management-led buyout.

Many ESOP design features help the owner achieve business and personal goals. This is true whether the owner’s goal is an immediate sale and exit from the company, to prepare for an ownership transition, or something in between. Look carefully at a custom-designed ESOP if these scenarios match your goals.

What To Consider When Evaluating An ESOP

To decide if an ESOP is a suitable option, consider the following:

  • Is the company in a labor- or people-intensive industry that can benefit from an ESOP’s potential to enhance productivity? ESOP-owned companies typically see a productivity boost often attributed to a boost in employee morale and sense of ownership.
  • Is the company in a cyclical industry with extreme ups and downs in stock value? If so, an ESOP may not provide the benefits employees expect and owners seek.
  • Is the company in an industry with a high risk of becoming obsolete? Could a change in technology put it out of business for reasons beyond its control? ESOPs are designed for longevity, so being a healthy company with a strong future is important.
  • Does the company have thin margins and poor cash flow that make a financed buyout impossible?
  • Does the company have enough employees and payroll to support contributions to the plan?
  • Does the company have a second level of management ready, willing and able to take over after the buyout?
  • Would the ESOP be the only retirement plan the company offers, or would a 401(k) or other plan also be available?
  • Does the owner have family members who want to take over control of the business? If so, this may preclude an Employee Stock Ownership Plan.
  • Is the owner willing and prepared to give up some or all control of the company and share ownership with employees?

Answering these questions will help determine whether an ESOP is right for long-range business planning. One thing that makes the ESOP process helpful is that most of these questions apply to any plan. In other words, if the owner and the company cannot implement an ESOP, they likely have a lot of work to do to prepare for the future and any kind of plan. This process can help initiate that preparation.

We’re Here To Help

Now you have an idea of how to evaluate ESOP plans for business planning needs. To explore this option more deeply, you’ll need to make some additional decisions. For instance, the ESOP will need trustees, and if the trustees will be company insiders, that role needs to be explained to them. You may want to explore other financing options or know what rights ESOP shareholders have. For tax reasons, you may want to change a C corporation to an S corporation.

These are just a few of the more advanced issues we help people navigate every day. To work with the preeminent Employee Stock Ownership Plan experts who can guide you to the right solution, contact Employee Benefits Law Group.

ESOP’s Tax Benefits

Our third installment looks at how the ESOP benefits the seller, the company, and the employees.

Learn More…

About Sheryl Bayani-Alzona

Sheryl guides her clients throughout the life of an ESOP, from the initial transaction and ongoing compliance and sustainability, through plan termination. Her clients rely on her when they are considering a liquidity event, a business succession plan, a plan to share equity with their employees, or as the first line of defense in the event of a DOL or IRS inquiry.
Learn More About Sheryl

EDITOR’S NOTE: We did the best we could to make sure the information and advice in this article were current as of the date of posting to the web site. Because the laws and the government’s rules are changing all the time, you should check with us if you are unsure whether this material is still current. Of course, none of our articles are meant to serve as specific legal advice to you. If you would like that, please call us at (916) 357-5660.