Employee stock ownership plans (ESOP) give ownership interest to employees in the form of stock shares. We’re going to break down what this complex deal looks like, including the potential benefits and risks, and why it’s critical to have a strong team in place to successfully guide you through the process and to the finish line.
What is an ESOP?
When a business reaches a certain maturity point, an ESOP can be an attractive substitute to an outside sale. If majority owners are weighing the possibility of an exit strategy, typical options include selling to a competitor or private equity. Remaining independent can be beneficial on many fronts, which is why employee stock ownership plans have gained traction as a new form of ownership structure. An ESOP is essentially a highly customizable leveraged buyout that enables business owners to partially or fully sell their shares and also enables the employees to own part or all of the company that they work for – yet the stock they own doesn’t cost them a penny. In simple terms, this is how an ESOP works: untaxed earnings and loans to a company are used to purchase shares of the company from the owner(s) on behalf of the employees. However, the employees don’t have the funds to make the purchase, so the business typically borrows all or part of the funds from a lender like Live Oak Bank. Then, the business lends those same funds to an ESOP trust which then purchases the shares from the owner and distributes those shares to the employees over a pre-determined vesting period.
Who are the key players involved?
If you’ve made the decision to do an employee stock ownership plan, the single most important thing to do is assemble a group of experienced professionals who can lead you down the right path. Typically, that begins with a financial advisory firm, who will architect a solid blueprint for the deal, and then implement that plan from start to finish. Once due diligence is complete and the structure of the ESOP is determined, then legal counsel helps to implement the transaction. Next, comes the trustee team. They conduct due diligence on the business, negotiate the price and terms of the transaction with the sellers’ representatives and oversee the legal entity that holds shares on behalf of employees. Finally, the business secures financing to fund the transaction.
Another imperative point when considering employee stock ownership plans is that it is not a “one size fits all” approach to taking some chips off the table. By no means are we convincing you to run out and decide to do an ESOP – many businesses are not good candidates for this type of transaction, be it financially or culturally.
To support the added leverage required to execute an ESOP, the business needs to have strong cash flow and a strong balance sheet. Companies who have been most successful in implementing an ESOP are those that did it for reasons other than financial gain. The primary goal should be to create a legacy for its employees and to bolster an ownership-minded culture.
Pros and Cons of an ESOP
There are considerable benefits to going the route of an ESOP but also some risks. Above all else, you stand to gain enhanced internal culture, as well as deeper employee engagement and retention rate. Studies have been conducted by the National Center of Employee Ownership connecting ESOPs to improved financial performance. The term “run it like you own it” holds true when your employees are actually co-owners.
There are also substantial tax and financial benefits. Under IRS Tax Code 1042, the owner can defer all of his or her taxable gains from the sale. Further, the corporation will have ongoing tax benefits post-transactions and if 100% of the company is ESOP owned, you pay no federal income tax and no state income tax (in most states.) It goes without saying that the financial implications of that could be a game-changer.
Where there are so many advantages, it only makes sense that there are also potential drawbacks involved in an ESOP. It’s essential to be mindful of any impending or future debt needs of the business before proceeding with an ESOP. Another possible peril is not structuring the deal properly on the front end. The ESOP trust should negotiate a reasonable period of time required to buy back shares of employees who leave the company, as the liquidity may not always be readily available, especially if multiple employees exit simultaneously. This underscores the importance of having an experienced team of professionals, including a financial advisor and lender, by your side throughout the ESOP process.
An employee stock ownership plan is not the appropriate ownership transition strategy for all companies. However, when executed at a suitable moment in time for the right business and with the best support team in place – an ESOP can prove to be the perfect solution.
Live Oak Bank does not provide tax advice. Please consult with your accountant.