Evaluating ESOPs as an Exit Path: Pros & Cons
As an Exit Planning Advisor, you may be faced with strong, contradictory opinions from your business owner clients on a variety of Exit Planning options. One exit path that many people have misconceptions about is Employee Stock Ownership Plans (ESOPs).
The confusion surrounding this exit path may be for a few reasons. The Employee Stock Ownership Plan (ESOP) is the main source of employee ownership in the U.S, however, ESOPs are not the only option available for employee ownership. Another misunderstanding is that this exit path requires employees to purchase stock or that it works like an equity compensation plan. Rather, ESOPs are entities of federal law, governed by many of the same rules as 401(k) plans, funded entirely by the company, and subject to oversight by the IRS and U.S. Department of Labor (DOL).
These misconceptions form due to the complex nature of this exit path. For the purposes of this article, we’ll leave government-created complexities to ESOP specialists. Instead, it will provide you, as an Exit Planning Advisor, with the pros and cons needed to make an initial recommendation to a client about whether they should pursue an ESOP.
The Appeal of an ESOP
To a business owner unfamiliar with this path, they may ask, “What is the purpose of an ESOP?
According to the National Center of Employee Ownership, “ESOPs are most commonly used to provide a market for the shares of departing owners of closely held companies, to motivate and reward employees, or to take advantage of incentives to borrow money for acquiring assets in pretax dollars.”
Simply put, an ESOP is a type of employee benefit plan that acquires company stock and essentially enables employees to own part or all of the company they work for.
The next question is typically along the lines of, “How does an ESOP work, and is my company a good candidate?”
The Process of an ESOP
In an ESOP, a company sets up a trust fund and then contributes new shares of its stock or puts in cash to buy existing shares. As an alternative funding option, the ESOP can borrow money (from a bank, seller, or both) to buy new or existing shares. With borrowed money, the company makes cash contributions to the plan so that it can repay the loan over time.
Employees can accumulate shares in their retirement accounts as they are allocated over time, and then cash out those shares when they retire or leave the company. These allocations are distributed to employees according to relative pay, or a formula that deems more equal distribution. At this time, employees receive a significant retirement benefit, and the owner reaps the benefit of securing a successor while being able to exit on their own terms. In addition, the ESOP provides continuity during the transition of ownership.
Just like every exit path, ESOPs come with a list of pros and cons. While this is not an exhaustive list, Exit Planning Advisors should be able to articulate these benefits and drawbacks to clients looking into an ESOP transition.
Pros of ESOPs as an Exit Path
Owners can receive the financial security they desire post-exit through partial or complete sale of their ownership interest. ESOPs also allow them to stay in control until they are fully paid, as well as enjoy effective control even after they are paid if they choose.
ESOPs can be designed to accommodate an owner’s departure date, as well as give owners the chance to leave gradually or remain involved in some way for those owners who face the fear of letting go.
Employee Satisfaction & Culture
A values-based goal of many business owners is to carry on the legacy and mission of their business beyond their exit. ESOPs give employees ownership rights, giving them a stake in the future growth of the company. This transfer method is more likely to continue the culture, legacy, and community impact of the business.
In addition, ESOPs generally include incentive plans for key employees.
There are several tangible tax benefits provided by ESOPs to both business owners, and employees:
The future income of S corporations is not taxed, allowing the company to invest and increase cash flow.
Proceeds from the sale of a business owner’s stock in a C corporation may be entirely deferred.
Payments made to the ESOP by the company are tax-deductible as they are then used to buy the business owner’s stock in the company.
Cash contributions to the ESOP are tax-deductible, whether used to buy shares from owners or to build up a cash reserve.
Loan repayment contributions to the ESOP are tax-deductible too, meaning that ESOP financing is done in pre-tax dollars.
Employees don’t pay tax on their personal contributions to the ESOP – only during the distribution period at the time of their departure or retirement.
Cons of ESOPs as an Exit Path
The cost to start and operate an ESOP can be substantial – NCEO states even the simplest of plans for small businesses can start at upwards of $40,000. Owners may also take on debt in this type of exit path, relying on the ability of the business to use future cash flow to pay off these debts to the owner.
If the owner does accept promissory notes for part of the purchase price, taking on the debt mentioned above, they can be exposed to long-term risk since repayment is subjective to the company’s future cash flow. Regardless of the owner’s exit timeline, this repayment could take a long time and added risk may stall or divert the timeline altogether.
Employee Satisfaction & Culture
Many owners hope that as a trade for ownership, employees will have higher motivation and performance given their stake in the company. However, ESOPs will only improve corporate performance if combined with opportunities for employees to participate in making decisions.
In this exit path, the successor is ultimately the employees; therefore, an ESOP would not be viable if the company’s management team won’t operate well with that model.
Lastly, the employees who are members of the ESOP choose to invest their retirement plan savings in a single company. This lack of diversification can put them at risk of losing their income and their savings if things go south with the business.
The IRS & Department of Labor (DOL) subject ESOPs to a high level of scrutiny and regulation due to the significant tax benefits the IRS provides to ESOPs. Additionally, ESOPs can’t legally be used in partnerships and most professional corporations.
Action Items for Exit Planning Advisors:
Regardless of exit path, the biggest benefit of Exit Planning as early as possible is that Exit Planning Advisors can help mitigate the disadvantages of the chosen exit path.
Regarding ESOPs, Exit Planning Advisors should keep their finger on the pulse of all government regulations and changes with these plans. They should also familiarize themselves with alternative recommendations to give to their clients so they can make suggestions on different exit strategies if the ESOP proves to be an ill-suited solution for a particular situation.
To learn more about ESOPs, or to gain knowledge on other Exit Planning solutions, schedule a meeting with BEI today.
If you missed the webinar featuring Kelly Finnell, Founder & President of Executive Financial Services, Inc. (EFS), you can watch the recording and download the presentation slides at the link below!