3 Things Every Business Owner Needs to Know About ESOP’s
Have you been thinking about a potential future sale of your company? Are you searching for ways to drive higher engagement and a deeper sense of ownership among your employees? Maybe you’re looking for a sharper competitive edge in an intensely candidate-friendly employment market.
If you’ve been kicking around any of these ideas, you may have wondered about an Employee Stock Ownership Plan (ESOP).
The truth is, making the decision to sell your business to an ESOP is a long, winding – and sometimes costly – road. The result? As an executive recruiter, I’ve seen how the prospect of company ownership can tip the scales in an employer’s favor when competing for top talent. But I’ve also seen ESOP’s that have become burdensome that they’ve threatened to sink otherwise profitable businesses.
Is an ESOP right for you? Maybe. Before you take too many steps down that road, take a closer look at what they are, how they work, and whether the benefits they offer make it worth the long-term personal and financial commitments they demand.
1. How do Employee Stock Ownership Plans (ESOP’s) Work?
ESOP’s are hardly a new idea. In fact, they’ve been around for decades. So, what is an ESOP, exactly? It’s a qualified retirement plan. But unlike a 401(k) – and as the name implies – an ESOP involves the sharing of company ownership with the company’s employees.
With an ESOP, the employer sets up – and funds – a trust through which stock ownership can be incrementally transferred to employees who earn shares of the company over time. As employees terminate or retire, they’re able to “cash out” those shares as part of their retirement savings. In order to make all of that happen, of course, that trust must be adequately funded. How? The ESOP must initially borrow cash that is then used to buy the company shares (from you, if you’re the owner). The decision to take on that debt is a consequential one, calling for rigorous up front analysis with solid legal and financial advice.
If this sounds complicated, I’m not going to lie. It is. It requires sound legal and financial advice – and a careful weighing of the long-term benefits and potential risks.
2. What are the benefits of ESOP’s?
There are many. As a headhunter, I’d like to start by focusing on one, in particular:
They Can Be a Powerful Recruiting Tool
By its very nature, ESOP’s have proven they can attract highly motivated individuals. These are people who are goal oriented and come into a job believing they’re capable of driving success – not just for themselves, but for their employer, as well. So the opportunity to reap the rewards of that success is highly appealing. The trick, of course, is being able to clearly articulate – and sell – your ESOP to candidates so they have a clear grasp of the benefits they’d enjoy. And here’s another sobering consideration: ESOP’s might not have the universal appeal they once did on the front end of the recruiting process. Why? Because they’re often marketed as “the big retirement reward” at the end of a long career. That’s a message that holds particular appeal for some job seekers. But today, more and more people just don’t look at their career with the intention of staying with one company forever.
They Promote an Ownership Culture
Multiple studies over many years consistently demonstrate a strong correlation between employee ownership and employee engagement, performance and innovation. ESOP’s promote longevity, giving people the sense that they’re stakeholders, long-term investors. Translation: you can expect happier, more productive people who are more inclined to stick with you, even during temporary rough patches.
ESOP’s have an Impressive Track Record for Driving Performance
Many non-ESOP companies, especially large corporations, provide opportunities for employees to own shares of the company. But in those cases, employees own a significantly smaller share of the pie. With an ESOP, employees own part (or often, all) of the company. And ownership is only a privilege of active employment. In other words, employees are stakeholders with serious skin in the game. Think about it. Imagine an organization where every single employee was as eager (or almost as eager) to see company valuations, sales results and profitability reports improve as you are. That’s an organization in which every employee is working toward common goals. And often, that’s an organization that enjoys higher sales, greater productivity, and improved employee retention.
You Can Preserve Your Company’s Culture, Even After You Step Away
As much as you love your business, there will come a day when you won’t be there. But that doesn’t mean you don’t want to protect the company, vision, and team you worked so hard to build. You’re not alone. Many successful, privately owned businesses are built around the unique leadership skills – and clearly articulated priorities – of their owners. As a result, a deeply ingrained company culture forms, based on shared goals, values and motivations. It’s what defines the company itself. So, what happens after the company gets sold and the leader departs? A different set of priorities take over. Sell to a private equity group and they’ll work rapidly to prepare your company for re-sale. And they’ll do whatever it takes to make that sale as profitable – by the short-term numbers – as possible. Company culture – no matter how precious to you and your people – just can’t be the top priority. (It’s rarely on the priority list at all.) An ESOP, on the other hand, turns over company ownership to the very people who value and will perpetuate the organizational identity and culture that you worked so hard to build.
3. Financial Considerations
As the owner, selling to your employees via an ESOP presents you with multiple potential financial benefits. First, if your personal wealth is heavily tied to your business, an ESOP can provide you with some liquidity. In addition, because of the ways in which ESOP’s allow companies to borrow money for their funding, an ESOP can help you defer (or avoid altogether) capital gains taxes on that sale. The ESOP must borrow cash in order to buy the company shares (from you). The company is then allowed to make tax-deductible contributions to the ESOP for the loan’s repayment. In other words, both principal and interest can be deductible.
But there are also potential financial downsides and long-term risks.
Even after the initial set up and funding costs, an ESOP will accrue the costs of ongoing third party administration, valuations, trustee and legal costs. Owners who miscalculate – or fail to take seriously – the implications of these ongoing costs can run into serious financial problems later. What’s more, the cash flow demands of the ESOP are significant. You need to be sure your ESOP won’t restrict your company’s ability to pursue other necessary business investments. Finally, keep in mind that the number one purpose of the ESOP is to repurchase the vested shares from every ESOP participant upon their termination or retirement. What if the worst case scenario occurs? What if the company goes through a prolonged slump or catastrophic event, causing the shares to lose value? Loyal employees can lose their jobs – and the value of their hard earned ESOP shares. To mitigate these risks, more and more companies have begun adding 401k’s to their retirement benefit mix.
4. What Kind of Company is a Good Candidate for an ESOP?
There are very few hard and fast criteria here. In fact, ESOP’s don’t discriminate by industry, size or geographic location. (But I will point out that here in the Midwest, we lead the way, boasting 32% of the nation’s ESOP’s.)
Because we’ve all heard of ESOP’s with tens of thousands of employees, it may surprise you to know that, according to the National Center for Employee Ownership (NCEO), even a company with fewer than ten employees might benefit from an ESOP. Likewise, even though a majority of ESOP’s today are in the manufacturing sector, they’re also prevalent in the service, construction and trade sectors.
In other words, the benefits of an ESOP are many. But the costs, legal requirements, long term risks and uncertainties are significant.
It’s not a short-term fix or something to enter into lightly. Given the funding requirements, going the ESOP route means you’ll possibly be financially tied to the organization for a much longer than if you simply sold to an outside buyer. If you’re looking to sever all ties in one fell swoop, this is probably not for you.
With some soul searching, a clear accounting of your business and personal priorities and honest advice from credible experts, you can decide whether an ESOP is truly right for you.