ESOPs: The Good, the Bad and the Ugly

Most business people have heard of Employee Stock Ownership Plans, commonly referred to as ESOPs, but not too many of us fully understand them. This is not surprising; they are very complicated. The typical reaction from a business owner when the subject comes up is that they have heard that ESOPs are not a good idea, but when asked to explain why they are at a loss. Yet there are more than 10,000 ESOPs in place and more than 8 million workers own shares in their employer’s success through an ESOP. An ESOP, like a lot of other financial tools, is right for some companies and not for others.

​ESOPs are the byproduct of Sen. Russell Long’s efforts to establish a federal program to promote the ownership of company stock by employees. But today they are often used by company owners as a corporate finance tool to accomplish personal objectives. Technically, an ESOP is a qualified, defined contribution employee benefit plan that invests primarily in the stock of the company establishing the plan. Consequently, though ESOPs are often used as a financial tool, they are regulated by the Department of Labor as an employee benefit plan. Companies ranging in size from a small consulting firm to United Airlines have established ESOPs.

An ESOP is “tax-qualified” in that the sponsoring company receives certain tax benefits in exchange for meeting specific rules that protect the interests of the participants, i.e., employees. Private company owners who sell shares to an ESOP also receive favorable tax treatment if they invest the proceeds of their sale in a certain manner. ESOPs are also categorized as “defined contribution” plans in that the company agrees to contribute a pre-defined amount to the plan on an annual basis, but doesn’t guarantee what the benefit, i.e., the company’s stock, will be worth when the employee leaves the company and is cashed out.

From the business owner’s perspective, ESOPs are a mechanism to gain liquidity for their shares when there are no obvious buyers for the company. They are also a vehicle to transition ownership without paying capital gains taxes, which is a principal reason private company owners institute ESOPs.

To establish an ESOP, the company sets up a trust on behalf of the employees. The trust acquires shares in the company and allocates those shares to the employees over time. The trust secures the funds to buy the shares from one of three sources: 1.) the shares can be given to the trust at no charge, in which case no financing is required; 2.) the company contributes cash to buy the shares; or 3.) the trust borrows money to acquire the shares. The final approach, called a “leveraged ESOP,” is the one that permits ESOPs to be used as a corporate finance tool, thus the one I will focus on.

Owners can sell part or all of their shares to the ESOP. If the owner wants to maintain control, he or she can sell a minority interest, but the price per share will be lower. In practice, however, it is possible to retain control of the company even when selling a majority interest. Because the ESOP is a trust, the voting of its stock is controlled by a trustee, a role typically filled by a committee of employees and managers and chaired by the business owner or a suitable puppet.

Additionally, if you sell at least 30 percent of your shares to an ESOP, capital gains taxes can be deferred on any proceeds reinvested in stocks, bonds or other securities of domestic public companies until those securities are ultimately sold. ESOPs are a tax efficient way for private company owners to diversify their assets, which is why they are so popular.

The way a typical leveraged ESOP works is that the trust borrows the money to purchase the shares using the company’s assets as collateral. The shares are allocated to the employees as the principal on the loan is paid off. Each year the company makes a tax-deductible contribution to the ESOP to amortize the debt. When an employee leaves the company, the shares they were allocated are purchased from them by the trust at the prevailing market price.

The Department of Labor requires the trust to have an annual independent business valuation performed to determine the fair market value of the shares. In the event that the company is worth more than the amount a bank will lend to the company (imagine that), the owner will be required to pledge some of the securities they purchase with their proceeds as collateral for the loan. Then, as the loan is repaid, the collateral is released by the bank.

There are three common reasons business owners choose to sell to an ESOP:

  • If you want to cash out when the M&A market is dormant, as it was from 2000 until just recently;
  • if you have the type of business where it is difficult to find a buyer;
  • or, if you want to reward your employees for their hard work in helping you build the company by sharing some of your wealth with them.
  • The tax benefits of selling to the employees through an ESOP certainly make it a more attractive option than most sales to insiders.

There are downsides to ESOPs, however, that need to be considered. The first is that a company has to be a certain size to make an ESOP practical. Mike Hartman, who serves on the board of Governors of the ESOP Association, believes that the minimum annual revenues before considering an ESOP should be $5 million. That eliminates most small businesses. The reasons for this are several, including the significant legal and administrative costs required to establish and administer an ESOP. Like any government-sponsored program, there is a lot of bureaucratic red tape involved with ESOPs. Just the legal fees to establish an ESOP typically run at least $50,000.

Businesses that do not have a large number of employees relative to the company’s value are not good candidates for ESOPs either. The annual contribution limit for a leveraged ESOP is 25 percent of payroll, so if the payroll is small compared to the company’s value, the trust can’t amortize the loan quickly enough. Also, companies lacking a strong management team capable of running the business after the owner retires are unlikely candidates for an ESOP.

First of all, the banks are rightfully leery of such companies and unlikely to fund the ESOP. Secondly, what owner wants to risk the proceeds of selling their company by collateralizing a loan that can only be paid back with future profits if the successor management team’s ability to deliver the profits is in question? For similar reasons, companies that already have significant debt or are in highly cyclical industries are not good candidates for ESOPs.

Finally, if an owner sells to an ESOP, and within three years a buyer for the company appears, the company has to pay an onerous excise tax if it is sold. This is the government’s way of preventing ESOPs from being used simply to dodge taxes. And if that buyer does come along, the upside of selling the company goes to the employees, not the business owner, unless he or she has maintained a significant interest. For that reason, estate planning lawyer Tony Turner of Mazursky and Dunaway believes that in most cases business owners who use ESOPs are giving their company away.

​So, as is often the case with financial tools, ESOPs are the perfect solution for some companies, and they are not well suited for others. The quotient of ESOP knowledge to ESOP conversation is extremely low among many business owners and a surprising number of CPAs. Therefore, if you are considering an ESOP, you should consult an expert in ESOPs and talk to business owners who have implemented them to hear first hand about their experiences before heading down that path.

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