An Employee Stock Ownership Plan, also known as an ESOP, is an employee benefit plan that offers advantages to business owners, their companies, and their employees. It is a tax qualified, defined contribution plan where employees own shares in the company (or in the parent company of a group of companies), and is unique among qualified employee benefit plans in its ability to borrow money.
Currently, there are around 7,000 ESOP plans in the U.S. NCEO (National Center for Employee Ownership) estimates that employees now control about 8% of corporate equity, with approximately 28 million employees actively participating in employee ownership plans. The COVID-19 pandemic has presented new challenges to nearly every company, and those that have ESOPS will have new issues to consider. However, ESOPS in general are still a great benefit to both the company and its employees.
Being part of an ESOP company can provide numerous employee rewards – receiving significant retirement benefits at no monetary cost to them for example. There are numerous benefits to the company as well. It’s a great way to enhance the company’s ability to recruit and retain top talent. Continuous employee communications that encourage employees to think and act like owners is necessary in order to generate these results.
There are, however, several myths regarding ESOP ownership, and they are often accepted by owners who are not properly informed and may prevent many companies from becoming employee owned. Let’s review.
Myth 1: After establishing an ESOP, a business owner must consult with employees on day-to-day management decisions.
Establishing an ESOP doesn’t change how a company operates on a day-to-day basis. The management remains in control of the company, even when the ESOP owns a majority. There is no loss of control of the company.
Myth 2: ESOPS are too expensive to the selling business owner.
ESOP transaction costs are similar to the costs that would be incurred by selling to a third party. If an owner chooses to change ownership, they will need to hire numerous consultants to achieve their goal; accountants, attorneys, etc. Selling to an ESOP is no different.
Myth 3: ESOPS are only for large companies.
Profitability of the company is more important than size. The company just needs to be large enough to generate a profit to support the annual costs of maintaining the ESOP. In a profitable S Corporation ESOP Company, the tax savings alone can be more than enough to offset the annual costs.
Myth 4: Companies will have to disclose detailed financial information to employees.
An ESOP is a qualified retirement plan, and thus participants must be provided an annual statement demonstrating the value and number of shares held for their benefit. No other financial disclosures are required. It is completely up to the company to decide if more detailed information will be shared.
Myth 5: An owner adopting an ESOP will get a lower exit value by selling to an ESOP than by selling through the open market.
This myth is possibly the most frequently heard, and most inaccurate from a valuation perspective. Like any financial buyer, an ESOP pays fair market value for the stock of the company. While a seller may get nominally less by selling to the ESOP, the tax savings generally make it comparable to selling to a private equity firm or another buyer. ESOPs generally increase the after-tax proceeds of a sale. The company can also take a tax deduction of up to 25% of payroll by making an ESOP contribution. Selling to an ESOP can also eliminate the ongoing tax or S-corporation distribution obligations of the company providing significant ongoing tax savings.
In my opinion, due to reduced or zero taxes which could result in excess cash flow of 40% or more, a sound ESOP strategy not only makes the new ESOP more competitive, it guarantees that the legacy of an owners company will survive in the market place. The sellers may benefit by paying little or no tax on sale. From an employee standpoint everyone still has their job and the fear of a third party purchasing the company and changing a great culture does not exist. By law, the ESOP trustee must pay fair market value (not less or more). In my experience, this makes the transaction a very friendly negotiation between the buyer (ESOP trustee) and the seller.