When owners are weighing exit options, an Employee Stock Ownership Plan (ESOP) can deliver an owner liquidity, preserve culture, and build employee wealth, all in one structure.
Q: From a high level, explain the basics of an ESOP. We know it’s an employee stock ownership plan. There’s a lot of great benefits to it, but how are they structured, just so we can get a first understanding there?
A: The answer to the question, “What is an ESOP?” is really a two-part answer. The first is, an ESOP is a retirement plan for a company’s employees, but at the same time, it’s also an exit and liquidity strategy for the company’s owners.
And so, the way an ESOP works is that when a business owner decides to exit their company by way of an ESOP, instead of via a sale to private equity or to a strategic buyer, they want to exit their company and at the same time take care of their employees by creating a retirement plan for them that is funded with the company’s stock.
The employees don’t purchase the stock that goes into their accounts. It’s contributed by the company and the company finances the entire transaction. And so, in ESOP, as a retirement plan is very similar to a 401k plan, but with three key differences.
- The first difference is that an ESOP can borrow money.
- The second difference is that it can engage in certain transactions with parties and interest.
- And the third difference is that an ESOP is required to invest primarily in the stock of the sponsoring employer.
So, when you take the fact that an ESOP is a 401k plan, with those three key differences, the way an ESOP is structured is as follows.
Most ESOPs are financed with a combination of bank debt and seller debt. So, the company goes to a bank, borrows money, takes that money and combines it with a seller note, which is simply an IOU promissory note issued by the company to the selling shareholder. So, the company has, or the ESOP has, those two sources of capital: cash from the bank loan and the promissory note, and it gives that to the business owners in exchange for their stock.
The business owners get cash and promissory notes, and the ESOP trust receives the stock in exchange for that. Then over a period of years, and it’s generally 20 to 40 years, that share is divided up or allocated among the company’s employees. And that allocation is done on a salary ratio basis.
So, if I have an employee who makes $200,000 a year and an employee who makes $50,000 a year, that $200,000 a year employee is going to get four times as many shares in his or her account as compared to the $50,000 a year employee. So that’s the structure. Then the company, because obviously these lenders want to be repaid, over time the company makes contributions to the ESOP, and the ESOP uses that to repay the bank principal and interest.
While that principal and interest is being paid, the company will pay interest only on the promissory note on the seller note. Then once the bank is repaid, one of two things will happen:
- Either the company will go back to the bank and borrow another tranche of debt to pay off the seller note, or
- The company will simply pay principal and interest on the seller note over a period of time.
For a business owner, it’s a way to cash out of their company, cash in on their life’s work, while at the same time benefiting their employees.
Takeaway
ESOPs let owners cash out while keeping the company independent and give employees a meaningful ownership stake tied to long-term performance.
