An Employee Stock Ownership Plan (ESOP) is an employee benefit plan that offers advantages to business owners, their companies, and employees. ESOPs help companies align incentives with employees by enabling them to become shareholders. Thus, ESOPs are a creative way for all stakeholders to invest in the company’s long-term success.
While ESOPs may appear appealing at first glance, they’re not for everyone. The best candidates for ESOPs have the following characteristics:
- Large cash flow and a history of increasing sales and profits. Volatile earnings will create unstable share value. Unpredictability can negatively impact employee sentiment, especially in recession years.
- Strong management. Shareholders need to feel confident in management’s ability to grow the business. A steady stream of cash flow is also required to meet future repurchase obligations of the ESOP.
- Diverse shareholder base (employees). A diverse shareholder base with a wide range of retirement dates is essential. A foreseeable timeline will help maintain a balance between cash flow needs.
But, qualifying for an ESOP is only the beginning. Several pros and cons should be considered before pursuing one.
- Built-in Buyer: ESOPs solve the issue of finding a buyer in an over saturated market.
- Tax Advantages: Setting up an ESOP can be expensive. But, tax benefits payout when it comes time to sell. Selling to a third party is more expensive.
- Benefits of Employee Ownership: ESOPs are an opportunity for employees to take ownership of the company. ESOPs can 1) improve the well-being of workers; 2) create greater participation in decision-making; 3) create higher pay, benefits, and wealth; 4) lead to increased job security and satisfaction; 5) increase trust in the company and management.
- Win-Win for Owner and Employee: ESOPs keep businesses in the hands of the people owners know and trust. In turn, they reward important stakeholders for their performance and loyalty while maintaining the legacy and stability of the business.
- High Expense: ESOPs are complicated and expensive to administer. First, a feasibility study is required and costs $40,000 minimum to conduct. (Colorado Legislature and OEDIT are addressing this issue. Read more here.) If approved, the plan will encounter annual fees. Legal, administrative, compliance, valuation and trustee fees are just a few. These are necessary services conducted yearly by expensive third parties. And, on top of maintenance costs, the company is responsible for repaying borrowed money if the ESOP was created through a leveraged transaction (loan).
- Lower Valuation: ESOPs eliminate a competitive selling process. Instead, a business appraisal determines the worth based on fair market value. Thus, depending on the business, a competitive bidding process may lead to a higher valuation for the company.
- Use of Resources: ESOP fees and expenses, plus repurchase obligations, mean less cash available. Limited cash flow impacts future growth, innovation, and talent.
- Increased Legal Risks: ESOPs are regulated under the Department of Labor and must adhere to the Employee Retirement Income Security Act (ERISA).The many limitations and liabilities businesses must subscribe to make the legal risks to trustees greater.
While ESOPs can be a great option for businesses, they require significant consideration. It’s a process that requires time and knowledge before a decision is reached.
Interested in learning more about ESOPs? Colorado-based Quist Valuation has 35-years’ experience with ESOP valuations. And with the new bill passed by Colorado legislature to support the development and implementation of ESOPs, Quist can help. A team of expert analysts can walk you through the process and prepare you for the associated state-driven revolving loan program.
Learn more about the Colorado ESOP Bill and its revolving loan program here.
Schedule a consultation with Quist here.