ESOP Pros and Cons

Employee Stock Ownership Plans (ESOPs) have been available to businesses in the United States since 1974. There are approximately 6,500 ESOPs in the country today with about 32 million people participating in these types of employee benefit plans. ESOPs are most frequently used as an ownership transition vehicle for retiring business owners who don’t want to sell the business outright. Instead, they form an ESOP and “sell” the company to their employees.

What is an ESOP?

An Employee Stock Ownership Plan (ESOP) is a defined contribution qualified retirement plan. ESOPs must adhere to the stringent rules and regulations set by the Internal Revenue Service (IRS), the Department of Labor (DOL) and the Employee Retirement Income Security Act of 1974 (ERISA).ESOPs allow employees to obtain an ownership interest in their employing company. As a plan participant, an employee is able to obtain company stock, which is held in an ESOP trust, until they retire or leave the company.

What are the Advantages of an ESOP?

ESOPs provide many advantages to both the company owner(s) and the employees.

• Ensures Continuation of the Business. ESOPs are popular with family-owned businesses and those that were started by the current owner. They provide peace of mind for owners who want to retire or transition away from the business but don’t want to sell it or shut the doors entirely.
• Unique Employee Benefit. ESOPs can be an attractive employment benefit for employees since they allow employees to simultaneously take part in the future successes of the company and save for retirement without any loss of current wages.
• Employee Motivation. The knowledge that they are part owner of their workplace can be incredibly motivating for employees. ESOP companies that foster an ownership culture report improved morale, greater teamwork, and a fresh perspective on the business among employees. These employees understand that their performance affects share value and ultimately, what will go into their own pockets via the stock.
• Tax and Investment Benefits. ESOP contributions are tax-deductible which allows employers to fund the ESOP’s debt service needs with pre-tax dollars. Additionally, S-Corp ESOPs are tax-exempt. This means that any profits made are not taxed and instead stay with the employees, generating greater wealth for participants. For employees, ESOP distributions can be rolled over to an IRA or other retirement vehicle which can provide tax benefits for them at the time of distribution.
• ESOP Sales are Fairly Quick. Owners who want or need to facilitate the sale of their business quickly usually find that ESOP formation takes far less time than a traditional sale or M&A.
• Owners Can Control the Transition Process. ESOPs are an ideal solution for owners who plan to retire but may not be ready to do so quite yet. ESOPs offer the flexibility to sell the business all at once or gradually over time and the former owner could stay in management or serve on the board if they choose to.
• They Can Provide Liquidity. ESOPs can be used to raise capital for the company, refinance debt, or expand by financing an acquisition. Owners can use ESOPs to diversify and create liquidity in their own personal portfolios.

What are the Disadvantages of an ESOP?

Just as there are advantages to an ESOP, there are disadvantages as well. ESOPs are not the best solution for every business, which is why we want to offer a look at both the pros and the cons of these plans.

• Limited to Fair Market Value. ESOPs are highly regulated by the IRS, DOL, and ERISA. ESOPs are considered financial buyers which limits them to paying Fair Market Value (FMV) for shares. When compared to a strategic buyout, for example, a business owner might receive less for the company by forming an ESOP than if they sold it to a motivated buyer.
• The Transition Can Be Tough. A strong transition plan is crucial to the success of an ESOP. Many ESOPs ease the current owner out while grooming new leaders to take over to minimize the disruption the ownership transition can create among employees and customers.
• ESOPs Need Independent Management. ESOPs require ongoing administration and management by independent advisors. ESOP trustees, like Aegis, are responsible for making fiduciary decisions, managing buy/sell transactions, ensuring all regulatory requirements are met, and monitor plan operations and performance every year. ESOPs are not plans you can set up and forget about. They have ongoing management costs.
• They are Not Suitable for Startups and Small Businesses. ESOPs are available only to C- and S-Corporations. There are cash flow requirements that must be met, which limits what is available for reinvestment in the company. Very small companies may not be able to afford an ESOP.
• The Balance Sheets May Scare Off Lenders. ESOPs create negative equity in a company. This can look alarming on your balance sheet and create a high debt ratio – on paper. Traditional lenders or those unfamiliar with ESOPs may shy away from working with you due to these factors, but there are plenty of ESOP-friendly lenders who see the value of ESOPs.
• Repurchase Obligations May Affect Future Cash Flow. ESOPs are required to buy shares back from exiting employees. This requires the company to have enough cash on hand to meet these future obligations, which can affect cash flow availability at the time.

Is an ESOP Right for Your Company?

As with many business decisions, ESOP pros and cons are highly dependent on the company in question. To learn more about ESOPs and for help determining if an ESOP is right for your company, contact Aegis Trust Company. Our team of ESOP professionals has completed over 400 ESOP transactions and can help you sort through the ESOP pros and cons as they relate to your business.