When it comes to rewarding your employees for their hard work and tireless effort, what is better than giving them an ownership stake in the company itself? With Employee Stock Ownership Plans (ESOPs) you can do just that and allow your employees to buy you out over time. The plans offer significant tax benefits for the employees as well as the company itself.

However, there are certain conditions that should be in place to ensure a successful outcome for everyone involved. Understanding the pros and cons of an ESOP can ensure the future success of the business and prevent demotivating employees or limit future growth potential.

What is an ESOP?

An ESOP is technically a defined contribution plan – a type of retirement plan according to the IRS. The ESOP is set up as a trust to which the company makes tax-deductible corporate contributions. Employees are also allowed to make tax deductible contributions to the trust, buying shares from the selling owners. Once an employee leaves, they get a distribution from the plan based on their shares at an appraised fair market value.

In other words, by setting up an ESOP, your employees can buy you out over time through their retirement plans. Or, if you set up a leverage trust, you can be paid out immediately while the employees buy the company back from the lenders.

In addition to offering tax benefits, ESOPs can offer a competitive price for your business. As Will Bloom of Chartwell Capital Solutions explained, “ESOPs can offer a very competitive, fair market value price.” He continued, “While it cannot pay strategic value since it offers no synergies, it can compete with any other private equity firm.” The combination can allow a business owner to save his legacy, while securing a nice exit.

The Ideal ESOP

Before even considering the ESOP option, your business should fit a certain profile in order to survive. A few of the characteristics of successful ESOPs are:

Strong Profits and Growth: As ESOPs aren’t usually part of a bidding process, they instead use discounted cash flow valuation methods to find the value of the company. The valuation method is sensitive to cash flow swings so solid, consistent profits over time provide the best value for everyone.

Good Management: Since you’re essentially selling your business to your employees, your company should have other competent managers to run the business as you exit. And the ESOP will become a long-term owner of the company, so it needs to ensure an ongoing flow of new management talent.

Diverse Employee Base: One other consideration that is often overlooked in an ESOP is the diversity of employee ages and interests. The ESOP is a retirement plan, so if too many employees are trying to leave at the same time the trust can be de-funded and make it difficult to keep the business running.

Assuming your company is private and profitable with a strong management team and a diverse set of employees, you may be a good fit for an ESOP. More than 11,000 companies are ESOPs and most are successful. However, because ESOPs are essentially an external party to the company there can be complications to some larger business transactions.

Raising Capital

If your ESOP-owned business is no longer generating steady profits and the company has already leveraged its assets, now what? Raising capital is complicated enough, and being ESOP-owned can add challenges. The added hurdle for an ESOP-owned business is that the shareholders need to be involved in the process of raising non-asset backed loans.

That means extra legal and financial advisory representation. Not only does the management need to approve on the investment, but the ESOP trust (the employees) need to approve as well. Employees can get scared, be slow to make decisions, or become emotionally attached in ways that third-party investors are not.

Acquiring Another Company

Very similarly to raising equity capital, when considering an acquisition, that added layer of due diligence remains for an ESOP. Below is a list of the parties involved in an acquisition by an ESOP:

Acquiring Company

  • Corporate Counsel
  • Buy-Side M&A Advisor

Target Company

  • Corporate Counsel
  • Sell-Side M&A Advisor

Acquiring Company ESOP Trust

  • ESOP Trustee
  • ESOP Financial Advisor

This added level of due diligence not only increases the timeline for the acquisition to finalize, but it also increases the likelihood of failure. More importantly, ESOPs are often less willing and able to consider an acquisition because the fees come out of the employees retirement plans. Plus, with many acquisitions creating a temporary decline in the value of the company, some employees nearing retirement may be reticent to back the deal.

Complications like these can disrupt a company’s culture and work dynamics. Given the hurdles involved with rapidly growing an ESOP-owned business, the most common strategy for the investors (the employees) is a strict buy-and-hold. Before a business owner sells his company to his employees, that company should be at a stage where its on cruise control toward a second liquidity event for the employees to cash out.