An employee stock ownership plan (ESOP) is a trust established by a company for the allocation of shares to employees. It sounds almost altruistic: A business owner works hard; builds a profitable, successful company; and then, out of the goodness of her heart, creates shares that she allocates to all her wonderful workers. Okay, I may be a bit snide here. The truth, ESOPs can work out very well for a business’s founder and her workers, and some owners really do want their employees to share in their success. But make no mistake: In nearly every case, ESOPs are created in the best interests of those who create them. In most cases, the creator is the business owner or the company’s top management, but sometimes the workers propose ESOPs. Getting an ESOP off the ground means establishing that the company is a valuable asset in its own right, which requires expertise and planning.
This post overview the following: (1) getting a handle on ESOPs and how they work; and (2) examining the details that make up an ESOP. Enjoy!
How ESOPs Are Created
In the conventional model for creating an ESOP, a business owner sets up a trust to which he makes annual contributions of stock, and that stock goes into individual employee accounts within the trust. Workers own stock based on their salary levels or years of service.
Printing stock certificates on your computer doesn’t make your company an ESOP. You need to fund the stock offering. Some companies use their own resources, get employees to contribute, or borrow money from banks, insurance companies, or private parties.
ESOP shares must vest before employees are entitled to receive them. Under rules set in 2006, vesting must be completed after three years (for cliff vesting — employees remain unvested during an initial period of service but become fully vested after that) or six years (for graded vesting — employees become vested in 20 percent of their accrued benefits after an initial period of service; they become vested in an additional 20 percent in each subsequent year, with full vesting four years later).
I am not going to get into the minutiae of the ESOP creation process because this post is just an overview. But it’s safe to say that you’re going to need a variety of experts — attorneys who have specific knowledge of ESOP creation, as well as your private attorneys, accountants, and financial planners.
ESOPs, like most major business transitions, aren’t born in a day. At least, they shouldn’t be. In a family business, you may need months or years to sell this idea to other family members, because the idea is all about sharing the wealth.
ESOPs Are Attractive in Certain Situations
According to the ESOP Association (), the two most common uses of an ESOP are to buy the stock of a retiring owner of a closely held company (probably a big issue for people reading this book) and to create an additional employee benefit or incentive plan to ensure the company’s growth. But ESOPs have other purposes as well, such as to finance a company’s expansion, spin off an operation into a separate company, or take a public company private.
In very few cases (about 2 percent), the ESOP Association says, ESOPs are formed as a last-ditch effort to bail out a company that’s dying — you see both employees and owners attempting to save companies in this way. This process isn’t for the squeamish.
You also hear about companies that create ESOPs to prevent unwanted takeovers. If a substantial amount of stock is in the hands of founders or employees, a company may be able to provide a united front against unwanted suitors.
Tax Advantages of an ESOP [How It Work]
Congress has provided certain tax incentives that make ESOPs a good deal for the owners of the business as well as for the new owners created by the ESOP:
- Deduction for ESOP contributions: ESOP contributions (in cash or securities) are tax deductible to the sponsoring corporation based on certain limits. When employers contribute their securities directly, they may take a deduction for the full value of the stock contributed. That deduction may allow an employer to increase her profits thanks to the taxes saved. If the ESOP is leveraged — that is, financed by a loan from a bank or other source — the tax advantages can be sweeter. Because contributions to a tax-qualified employee benefit plan are tax deductible, thereafter the employer may deduct contributions to the ESOP that are used to repay not only the interest on the loan but principal as well.
- ESOP rollover: Keep in mind that an ESOP allows a shareholder or group of shareholders of a closely held company to sell stock in the company to the firm’s ESOP and defer federal income taxes on the gain from the sale. The ESOP must own at least 30 percent of the company’s stock immediately after the sale, and the seller(s) must reinvest the proceeds from the sale in the securities of domestic operating corporations within 15 months (3 months before or 12 months after the sale). This tax break isn’t always available to current or retiring owners.
- Deduction for dividends: Employers who create an ESOP also get a tax deduction for cash dividends paid on stock purchased with a loan for those ESOP securities. A deduction is also available for dividends paid on ESOP leveraged stock to the extent that the dividends are used to reduce the principal or to pay interest on a loan incurred to buy that stock.
How Valuation Comes Into an ESOP
I start this post by saying that the U.S. Department of Labor — which puts out most of the rules and regulations for ESOPs — demands that you get an appraiser trained in ESOP work to do a valuation of the company to determine what the ESOP will actually pay for all or part of the company. Remember that the ESOP represents the employees who have a majority or minority ownership stake in the company.
This process gets pretty complicated. For full details, you can consult plenty of books on ESOPs. But valuation experts in an ESOP situation do the same thing that valuation experts do in other situations: They value the assets of the company and apply certain discounts to their price based on certain facts about the way the company will be owned and how marketable it would be to new buyers if an ESOP were in place.
Bottom line: Setting up an ESOP for your company isn’t like giving yourself a hammer to break a piggy bank with. An ESOP is a complicated strategic transaction that has consequences for the value of the company based on the way you structure it. The appraiser or valuation professional isn’t the only expert you involve in this process; you also need to work with estate and tax attorneys, as well as financial advisors.
Get a Handle on an ESOP Launch Steps
Setting up an ESOP involves not only time but also a fairly considerable paper trail. Here are just a few of the tasks involved over the time it takes to form an ESOP:
- Hire attorneys to design, draft, and implement ESOP plan documents and various trust agreements.
- Work with these attorneys to obtain favorable determination letters from the Internal Revenue Service.
- Create ESOP feasibility and business succession studies.
- Start your business succession plans.
- Consider and put into place the financing options to launch the ESOP.
- Structure and record ESOP and related transactions.
- Advise fiduciaries on the status of the transition.
- Inform clients and customers.
- Settle all legal matters that could threaten the transition.
- Change over all tax-reporting structures to fit the ESOP structure.
You always need a valuation professional who understands your industry and the particular objective for which you’re doing the valuation. Anyone who does your valuation work on an ESOP should have verifiable experience in valuing ESOPs.
Preparation Costs on Doing ESOP
No one-size-fits-all cost applies to doing an ESOP, but fees are the only really easy thing to quantify in this process. Attorneys and tax/valuation experts may cost anywhere from $10,000 to $20,000, but you can vary those amounts based on how much preparation and study you bring to the process.
The tougher part to quantify is your time, especially the time you need to spend educating your officers and employees about the process. An ESOP isn’t something that you can do — or should do — in a couple of months. The best-laid ESOPs are planned well in advance, with firm ideas about how that ownership structure will serve the growth of the company going forward.
Training Next-Generation Leadership for ESOP
Training next-generation leaders is the succession-planning component of the ESOP process. If the ESOP enables a primary owner or a founder to retire with a sizable cash payment, it doesn’t signal the end of that person’s interest in the company. Family and friends will remain, and it’s in everyone’s best interest that the value of the company be maintained over the long term.
Many owners plan an ESOP well before their retirement — sometimes, 10 to 15 years before. The advantage is that not only do you get to review and assemble management talent for the next generation, but you also get to oversee the cultural change that ESOPs should bring. If you’re making owners out of your officers and staff members, they should start acting like owners, setting and reaching performance targets that should guide all their actions going forward.
Ongoing Training for Employees
You can’t stop looking for talent on the lower rungs of top management. In an ownership culture, you need to train and educate employees at all levels about what’s going on with the company so they know exactly what their responsibilities are in continuing to build value at the company they will own.
This process is important because a company stops being a paternalistic organization the minute it becomes an ESOP. The organization still has leaders and employees, but tremendous advantages exist when you make employees at all levels aware of what it takes to keep the company growing.
ESOP Costs after Launch
According to the National Center for Employee Ownership, a company with 20 employees might spend $2,000 a year for plan administration costs, such as filing reports, keeping records, and sending account statements, plus an additional $30 to $60 per employee for special situations such as retirement or plan asset allocations.
Also keep in mind that if a company has to borrow to launch the ESOP and the loan comes at a high rate, it’s particularly important to think carefully about how that debt will be managed and eventually extinguished — which brings us to the last and most important item, which follows.
ESOPs Can Fail
The idea that ESOPs can fail is an important one. In fact, one of the biggest ESOPs in history came dangerously close to failing. The Tribune Company, parent of the Chicago Tribune newspaper, was transformed into an ESOP as a way for real estate investor Sam Zell to take over the company in mid-2008. Thanks to factors including the failing economy and the rapid decline of the newspaper industry, the company filed for bankruptcy protection by the end of 2008. Reports circulated that the company’s employees were particularly vulnerable because their accounts were 100 percent invested in company stock, which can be decimated by bankruptcy. When considering bankruptcy, owners and all their experts need to be particularly vigilant about the prospects of the company’s industry and all the possible disasters that may happen.