The Potential & Pitfalls of an ESOP
Business owners looking to exit their business are often curious about setting up an Employee Stock Ownership Plan. An ESOP basically allows an owner to sell the business to his or her employees, who then become shareholders of the company. This can be an attractive option when you read about the potential tax benefits and implications for your employees--not to mention your legacy--but proceed with caution. ESOPs are not a good move for every business. They are complex, expensive and, for some businesses, not viable. ESOPs can also open a business up to legal action, so be sure you understand the risks of an ESOP and know your options before moving forward.
We’ll lay out some basic information in this post, along with some of the pros and cons. If you’re considering an ESOP, be sure to research your options thoroughly with the help of your trusted advisors before deciding the best option for your business.
The ESOP was invented in the 1950s, though it was largely unheard of until the 1970s. The basic idea was to sell shares of the company directly to employees. This served as both a reward for years of hard work and motivation for employees to act in the best interests of a company in which they were literally and figuratively invested. The first ESOP was a protective measure meant to preserve the legacy of a newspaper business when its owners retired. Today the ESOP is the most common form of employee ownership in the U.S.
Advantages of an ESOP
ESOPs are an attractive option for several reasons.
- Built-in Buyer
For the large number of baby boomers looking to sell their businesses, an ESOP can solve the contentious issue of finding a buyer in a market on its way to saturation with businesses for sale.
- Tax Advantages
ESOPs can offer a number of tax advantages—provided the business meets a long list of regulations. And while setting up an employee stock ownership plan is very expensive, it can be less costly than selling the business, depending on the business, its structure and long list of other factors.
- Employee Ownership Within Reach
For employees, an ESOP represents an opportunity to take ownership of the company, potentially with little upfront personal expense.
- Both Owner and Employee Benefit
Middle-market companies can usually accomplish their ESOP goals with a carefully planned exit strategy. The ESOP then has the potential to reward key managers and employees for their performance and loyalty while maintaining the legacy and stability of the business. The company remains in the hands of people the owner knows and trusts. This can reflect very well on the owner who chooses to put his or her employees at the helm and sale to an ESOP can be gradual or all at once, giving the owner flexibility in how to exit the business.
Disadvantages of an ESOP
As attractive as all this may sound, ESOPs are not for everybody. They come with exacting conditions and many limitations and liabilities. Your company’s ability to utilize an ESOP depends on its structure and not every company meets the legal requirements necessary to institute such a plan. The tax benefits, while attractive, are also carefully regulated and depend on their own variables, including the structure of the business.
- High Expense
ESOPs are extremely complex and comparatively expensive to administer. For the simplest plan, an owner can expect to pay a minimum of $40,000 just to get the ball rolling. For the life of the plan the business will encounter legal, administrative, compliance, valuation and trustee fees due annually to third parties. There are also transaction fees surrounding the addition of new employees and the retirement of established ones.
In addition to these fees there’s the matter of repaying the loan that bought the shares in the first place, because in an ESOP a trust borrows money to buy the company and then uses cash to repay that loan.
- Lower Valuation
When an ESOP purchases the shares of a business, it does so based on a theoretical valuation report from a qualified firm. This valuation can be significantly lower than what a competitive selling process could achieve with multiple interested buyers and investors. It depends on the business, but in the majority of cases a company can receive a valuation for the purpose of selling 20-30 percent higher than an ESOP valuation.
- Draining Resources
These fees and payments, plus the repurchase obligations of an ESOP, mean less cash is available to invest in growing the business, hiring talent, exploring new markets, etc. The constant strain on cash flow and liquidity can stifle the business’ ability to invest in growth and innovation, which now take a back seat to funding the ESOP.
- It’s Complicated
ESOPs are extremely complex and getting an unbiased opinion about them from the industry is challenging because many of the parties involved benefit in the form of third party fees. To avoid conflicts of interest, many plans hire an independent trustee to serve participant interests as well as outside firms to manage plan administration and record keeping. On top of this, Fiduciary Liability Insurance is recommended to protect the business against any claims of mismanagement of employee benefits.
- Legal Liability
Despite these precautions, the number of lawsuits associated with ESOPs are on the rise. And if an ESOP fails, it can create significant legal risks for the trustees.
- No Turning Back
ESOPs are very difficult to unwind because participants have broad voting and shareholder rights. A single participant has the ability to derail a fair transaction. Even raising capital is problematic, as new investors often prefer to avoid diluting employees’ shares or open themselves up to lawsuits claiming they undervalued the equity of the company.
The Bottom Line
Ultimately the decision of whether an ESOP is right for you depends on your unique situation. It could be ideal or it could be a legal disaster. There is no formula; only a careful look at your personal situation will tell.
Like any business transition, setting up an ESOP takes time and planning. With so many regulations and complex requirements, talking with a professional first to determine the best path for your business will save you time, money and legal trouble. If you're wondering whether an ESOP is right for your business, give us a call. OneAccord Capital specializes in the sale and acquisition of small to medium sized businesses in the Pacific Northwest and can help you decide whether an ESOP is a good option. Contact us today via email or call 425-250-0883 to speak with an expert about your transition plan.