Employee Stock Ownership Plans (ESOP) Can Help Business Owners Retire
posted by Nathan Fisher March 20, 2019
Are you thinking about your transition out of your business but concerned about selling to an outsider? There’s an option that can set you up for a comfortable exit while rewarding those employees who have helped make your business a success: The Employee Stock Ownership Plan (ESOP). Here’s how these plans work, how to tell if they might be a good fit for you and your business, and how to get one started.
What is ESOP?
An ESOP is a tax-efficient way for a business owner to sell some (or all) of their equity stake in their business to a group of employees, who raise capital from a lender. This can provide the owner with some immediate liquidity as well as a structured path to retirement, while also providing long-term employees the opportunity to create wealth. As just one example, WinCo Foods created an ESOP where a single stock contribution of $5,000 to an employee in 1986 has since grown to be worth $863,000.1
How is an ESOP set up?
In an ESOP, a business owner sells his or her company to the employees.
1. In order to establish an ESOP, the company selects a trustee for the new ESOP plan and builds an ESOP Committee from the current employee base.
2. Then, the business establishes a fund dedicated to the plan made up of either newly created stock or cash to pay for the purchase of existing stock.
3. In the case that the ESOP Committee will be purchasing existing stock, a bank can finance the transaction by loaning money to the company.
4. The company then loans money to the ESOP Committee to buy stock from the existing owner or shareholders.
In order for an ESOP to work, the owner doesn’t necessarily need to sell all of their equity and exit immediately. They can stay working for the company with the promise of receiving future payments for additional stock in the future. Then, over the years, the business continues to contribute money to the trust, which pays the owner for additional equity per the agreement. Those contributions may be tax deductible.2 The owner can also take “warrants” as part of the plan which essentially act as stock options, allowing the owner to retain some ownership in the company.
401(k) vs ESOP
A big part of the value of an ESOP is that it helps both the owner and the employees prepare for the future. The owner gets money for selling the business, and the employees who buy in get to build wealth over time. That said, an ESOP is not a replacement for a 401(k)-style retirement plan. Often, both are offered together as a complement to one another:
• The 401(k) provides employees the ability to build diversified investment portfolios aimed at providing for income needs in retirement.
• The ESOP, then, can help employees build wealth on top of those income requirements satisfied by the 401(k).
And though these plans don’t have the exact same application, there are some similarities. Both types of plans are regulated under the Employee Retirement Income Security Act of 1974 (ERISA) and provide tax advantages, such as tax-free contributions for employees.
What kinds of businesses are a good fit for ESOPs?
ESOPs are most often a good fit for both C and S-type corporations. These plans work best for companies with staff of at least a few dozen and a valuation of several million dollars. Several years of consistent cash flow is important, to offer employees a confident idea of their stock’s worth in the future. Additionally, ESOPs are best with a stable workforce with little to no turnover; under an ESOP, the company buys back stock from any departing employees.
If your company fits all these criteria, the next most important judge of a good fit is your goals for the future of your business. ESOPs are best suited to companies where the employer truly values the corporate culture they’ve built and want to maintain that even after leaving. That’s what led Kim Jordan, CEO and co-founder of New Belgium Brewing Company, to pursue an ESOP for her business. Especially when the prospect of literally selling the company to future generations within your own family might be a sticky one, this is a great way to keep the company “in the family” so to say and reward hard-working employees.
Are there any drawbacks to ESOPs?
In an ESOP, employees are investing heavily in a single stock. That means their investment is tied heavily to the financial status of the company; if the company decreases in value, the ESOP may also. This isn’t a reason to avoid ESOPs, but simply reinforces the importance of diversification for anyone investing for the purposes of funding retirement. ESOPs really must supplement retirement assets from a well-run retirement plan, not replace them.
Additionally, these plans are complex. They require an active ESOP committee that works diligently with credible partners and follows prudent processes. ESOPs require additional administrative work and cost. For example, companies must provide annual valuations of stock, which should be done by legitimate experts. All this is to say that ESOPs should not be entered lightly. They take work, but in the right circumstances, that work is well worth the effort for all parties involved.
How Can I Start Exploring an ESOP for my business?
If this sounds attractive, the first step is to enlist the advice of an ESOP consultant. These experts work with you to conduct a feasibility study. They’ll determine if an ESOP fits your objectives as well as the tax and financial positions of the company. They can also help prepare a 10-year simulation showing equity ownership, cash flow, warrants, tax implications, and loan details.
In the right circumstances, an ESOP can fit nicely alongside a 401(k) plan to give both you and your employees a chance to prepare for a dignified retirement—and build some real wealth along the way.