ESOPS: Myths vs. Facts

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By Dan Weinmann,
Managing Director

If you are contemplating ownership transition, and your management team is capable of running the business, an employee stock ownership plan (ESOP) may be on your list of options to consider.

An employee stock ownership plan (ESOP) is an ERISA trust that invests primarily in the securities of the employer Company. A sale to an ESOP is a tax advantaged management buyout (MBO) method that provides significant tax advantages to the Company and often the seller. Tax advantages ranging from the deduction of principal on ESOP formation debt up to the complete elimination of income tax for 100% ESOP owned S-Corps create a tailwind for these transactions, helping ensure success after management takes over the business. There are plenty of other non-financial reasons to consider an ESOP, but the tax benefits can be compelling.

In many situations, these benefits of an ESOP make them an attractive transition option for business owners. However, myths surrounding the creation and maintenance of an ESOP may make some business owners wary of this option. Below, myths regarding Control, Ownership, Structure, Size and Cost, Transaction Value and Employee Age are dispelled.

Control

Myth: “I will have to give up control of my business.”

Fact: Control of the ESOP is maintained by a Trustee, who is often the selling shareholder or member(s) of the management group. Very few decisions are required to “pass through” to the ESOP participants.

Ownership

Myth: “My employees will own the Company and have access to my financials.”

Fact: ESOP shares are owned through retirement accounts, not by individuals. Required financial information is limited to share values in participants’ accounts, which is determined by a third party valuation firm annually.

Structure

Myth: “You need to sell 30% of the Company in order to have an ESOP.”

Fact: When structuring an ESOP, 30% is only the minimum percentage in order to qualify for C-Corp tax deferral under 1042 rules. Otherwise, any amount of shares can be purchased in an ESOP.

Size & Cost

Myth: “Your company is too small for an ESOP. It costs too much.”

Fact: Any size company can form an ESOP. Administrative costs (TPA) are similar to those associated with 401(k)s, plus the annual valuation. Initial ESOP valuations are usually $10-25 thousand up front, and then less for annual updates. Other than the formation and funding for repurchase liability, there are no other significant costs to create or maintain an ESOP.

Transaction Value

Myth: “A sale to an ESOP will not result in highest price.”

Fact: While this may be true in some markets with some companies, each transaction is different, and the final agreed upon sale price depends on the market, specific situation of the company and valuation firm. Many times an ESOP buyer can pay the highest price for a company.

Employee Age

Myth: “My workforce is too old and near retirement.”

Fact: Early retirees actually help to distribute the ownership of an ESOP, and can be planned for. If a workforce is mostly older, the Company will have repurchase obligations coming to them earlier. This may cause a liquidity need. However, flexibility options exist that can be built into the ESOP plan, such as deferral of repurchase payments while the ESOP formation debt is being serviced, delays in the start of payments to participants and the stream of payments to participants.  Additionally, if an older workforce starts to retire within a few years after formation, not all of the stock would have been allocated and the company has less time to grow its valuation. This results in less shares being redeemed, and for less value than if they had been there longer.

When reviewing your transition options, if you find your management team capable of running the business, regardless of whether you think they “have the money” to buy you out, contact us. Your business could be an ideal candidate for an ESOP, and we have been able to finance management teams for both management buyouts (MBOs) and ESOPs with little or no equity.

© Copyrighted by EdgePoint. DanWeinmann can be reached at 216-342-5860 or via email at dweinmann@edgepoint.com.
 
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