Weighing the Pros and Cons of Employee Stock Ownership Plans
Employee stock ownership plans (ESOPs) offer numerous benefits for both employees and employers and should be considered as an alternative exit strategy for business owners looking to transition their company. As of 2018, there are an estimated 7,000 ESOPs covering more than 14 million employees. Even though ESOPs are popular, that doesn’t mean they are right for every organization. Below are a few pros and cons of ESOPs to consider when determining if an ESOP is right for your company.
Company Performance & Employee Benefits
Studies have shown that companies with ESOPs see better results. Analysis captured by University of Iowa, Villanova University and Indiana University found companies with significant employee ownership could expect to be 4 percent more profitable than their non-ESOP peers. Similarly, a Washington State Study found that ESOP participants earn more money and have more retirement assets than workers in similar non-ESOP companies.
What is it about ESOPs that leads to positive company performance? Ownership. When employees have skin in the game, they tend to work harder toward company success. ESOPs can assist in aligning employee goals with company goals, which improves organizational performance and rewards employees for company achievements. In successful ESOPs, a virtuous cycle occurs. Employee engagement and an owner perspective drive improved financial performance, which directly increases participants’ retirement benefits.
Roughly two-thirds of ESOPs are used to provide a market for the shares of a departing owner. An ESOP can help to ensure the continuation of the business and offers a great deal of flexibility and advantages. For a business owner, an ESOP allows for a greater deal of internal control over the transaction and can take less time to implement compared to an external sale. With an ESOP, the business owner can decide if he or she wants to sell all ownership or transition ownership gradually over time. Utilization of an ESOP to create liquidity for a minority stake does not preclude an owner from selling the company to a third-party in the future. ESOPs also help business owners gradually begin the process of converting their closely held ownership over to liquid, diversified capital. Lastly, ESOPs can be put in place long before a departing owner retires, providing the business with a well-defined succession plan.
One of the main benefits of ESOPs is the tax benefits they offer. Contributions to an ESOP are tax-deductible and employees pay no tax on the contributions they make until they leave or retire.
There are also a number of attractive tax and investment benefits when using an ESOP for succession planning. For example, the principal amount of an ESOP loan can be tax-deductible, so a loan used to finance the ESOP transaction can be repaid by the company with pre‐tax dollars. A selling shareholder can elect Section 1042 tax deferral treatment and may be able to indefinitely defer capital gains taxes associated with the sale of his or her shares, upon the satisfaction of certain requirements. Furthermore, for companies who elect S-Corp status, the ESOP’s share of recognized earnings is usually exempt from income taxes.
Not a Strategic Buyer
Current shareholders are unlikely to maximize proceeds from a sale to an ESOP, as the ESOP is a financial buyer, not a strategic buyer. The ESOP can only pay up to full fair market value. If selling 100 percent of the company, outside lenders may be unwilling to finance the full purchase price of the company stock, and seller-financing may be required to cover the balance.
Even though companies with ESOPs tend to succeed, that doesn’t mean ESOPs are the right fit for every business. Because ESOPs incent employees to think and act like owners, it’s important for the workforce, or at a minimum, the leadership team to be educated and well compensated.
Successful ESOP companies typically have solid cash flow and a history of profitability. As many ESOP transactions include a leverage loan transaction, the company must have consistent and expected cash flow to service debt with a margin of safety.
Successful companies with ESOPs often see improved company performance, but unsuccessful organizations may see the opposite. If the company isn’t profitable, employees may feel like their contributions are for nothing, hurting morale. Additionally, if the company isn’t profitable, the tax benefits each ESOP holder was offered are deferred or lost.
ESOPs can be an administrative burden with required annual valuations, plan administration, increased legal fees and likely the fee of an ESOP trustee. Companies considering an ESOP should research all costs and understand the potential administration costs and their impact on cash flow.
Employee redemptions, whether due to retirement or early departure, can have a significant impact on cash flow. When drafting your ESOP plan provisions, these anticipated redemptions should be considered and a strategy developed in order to protect the company’s cash flow. Please consult with an experienced ESOP trustee/attorney to discuss strategies such as installment payments, delayed payments and whether or not shares should be redeemed or recirculated.
In the end, ESOPs have the potential to bring big benefits but it’s important to weigh the costs vs. the benefits the plan may bring. Perhaps former Indiana State Treasurer Richard Mourdock said it best. “An ESOP is not a silver bullet or magic pixie dust, and running a business is always tough. Converting a failing company into an ESOP is never a good idea, and many ESOPs that failed were created as a last-ditch effort. The truth remains that thousands of large and small ESOP companies, some 100 percent employee-owned and others partially employee-owned, are succeeding during these difficult times because of the entrepreneurial environment created by the ESOPs.” He goes on to say, “ESOPs may appear complex, but they are simply a retirement plan that allows employee-owners to have a real stake in their future.”
If you’re thinking about offering an ESOP at your organization, I encourage you to speak to an experienced attorney, accountant and a commercial banker at First National Bank. We have people on our team who would be happy to walk through the pros and cons of ESOPs in more detail.
About the Author
John Grose is a Managing Director in the Commercial Banking Group for First National Bank. In this role, John and his team support closely held and family-owned businesses with comprehensive banking services. John began his career at the bank as a mergers and acquisitions analyst where he assisted in providing buy- and sell-side advisory services to small and middle market enterprises.
John received a BSBA from the University of Nebraska Lincoln and an MBA from Creighton University. In addition to his contributions as Treasurer for the Business Ethics Alliance, he sits on the board of Angels Among Us, the First National Community Development Corporation and the Association for Corporate Growth. John and his wife, Marla, have two children, Kennedy and John.