Last updated on July 2nd, 2019 at 09:19 am
Employee Stock Ownership Plans (ESOPs) can be an attractive way for an owner to sell a company and for employees to gain an ownership stake. ESOPs are qualified retirement plans that buy, hold and sell company stock for the benefit of employees. One of the main reasons ESOPs are often dismissed by business owners (and their advisors) as a legitimate succession planning option is due to the many unfounded misconceptions about them. In reality, many businesses are a perfect fit for ESOPs, but the business owners will never know because they think selling to a private equity or other third-party buyer are their only legitimate alternatives. Discussed below are some of the most common myths associated with ESOPs (sometimes referred to as “ESOP fables”):
- Myth: After establishing an ESOP, a business owner must consult with employees on day-to-day management decisions.Fact: Business continues as usual the day after a company becomes an ESOP. The officers of the company (president, CEO, other key leaders) make the decisions in ESOP companies (just like most non-ESOP companies), and they answer to the company’s board of directors. The board of directors should change following an ESOP transaction, particularly one in which majority control shifts (i.e., more than 50 percent of the stock is sold to the ESOP).
- Myth: ESOPs are too expensive to the selling business owner.
Fact: Other succession planning alternatives (such as use of a business broker or investment bank) are much more expensive than ESOP expenses. For example, in most third-party sales with a business broker or investment banking firm, a commission or “success fee” will be charged as a percentage of the sales price. This amount often far exceeds what would be charged for an ESOP transaction, which is done on an hourly or fixed fee basis. Moreover, because of the tax advantages (state and federal) which may apply to ESOPs, the transaction fees are often minimal by comparison.
- Myth: ESOPs keep all an employee’s eggs in one basket.
Fact: ESOPs are required to allow up to 50 percent diversification (i.e., liquidation from employer stock to cash to invest in more traditional investments like mutual funds) when a participant reaches age 55, with 10 years of participation in the plan. Also, an increasing percentage of ESOP companies also have a 401(k) plan, which adds another retirement savings opportunity for the employee.
- Myth: ESOPs are only for large companies.
Fact: Profitability of the company is more important than size. Many ESOPs are as small as 12-15 employees with less than $1 million in annual revenue. The company just needs to be large enough to generate a profit to substantiate the annual costs of maintaining the ESOP. In profitable S corporation ESOP companies, the tax savings should be more than enough to offset such annual costs.
- Myth: An ESOP transaction requires that a majority of stock be transferred.
Fact: ESOP transactions can be done for as little as 1 percent, and as much as 100 percent, of a company and everything in between. Yet, many business owners eventually end up selling all of their stock to the established ESOP because it is a “willing buyer” and the tax advantages of being a 100 percent ESOP-owned company are too tantalizing to resist.
- Myth: An owner adopting an ESOP will get a lower exit value by selling to an ESOP than by selling through the open market.
Fact: This issue is often the elephant in the room from a valuation perspective. While a seller may get nominally less by selling to the ESOP, the tax savings generally make it comparable to selling to a private equity firm or another buyer. ESOPs generally increase the after-tax proceeds of a sale. The company can also take a tax deduction of up to 25 percent of payroll by making an ESOP contribution. Selling to an ESOP can also eliminate the ongoing tax or S corporation distribution obligations of the company, providing significant ongoing tax savings.
- Myth: The Department of Labor is heavily focused on ESOP valuations. Those who adopt an ESOP may become a target.
Fact: Several lawsuits by ESOP participants post-2008 led to some additional scrutiny by the DOL about the stock valuations of ESOPs. When valuations fell post-2008, some questioned whether companies inflated valuations when creating the ESOP. The good news is that this scrutiny led to very clear guidance from the DOL on how to properly value ESOPs. This new guidance spells out a detailed process that requires independent valuation and the avoidance of conflicts of interests. In fact, the new valuation guidance may reduce the risk of DOL scrutiny.
- Myth: ESOP companies are less competitive in the marketplace than non-ESOP companies.
Fact: An S corporation ESOP actually has a distinct advantage over non-ESOP companies due to exemption from federal/state taxes (more than 80 percent of states follow the federal rule). The tax savings can quickly accumulate and the cash can be used for reducing debt, capital investment or even making acquisitions.
As a business owner can see, after looking behind the “ESOP fables,” selling to an ESOP might be the best alternative for an owner and should be at least considered as an exit strategy. This is especially true in cases where the owner wants to reward his or her employees for their hard work in contributing to the company’s success.
Bryan Browning is managing director at Valuation Research Corp. and Timothy Stewart is an attorney at DeWitt Ross & Stevens. This blog accompanies the May 4 BizTimes Milwaukee cover story, which focuses on ESOPs.