Sharing Success Through an ESOP
Why Employee Stock Ownership Plans Can Create Happy Owners, Workers and Positively Impact the Bottom Line
By Timothy J. Desmond, CPA, Partner and John Vitucci, CPA, Partner
Employee stock ownership plans (ESOPs) can provide significant benefits simultaneously to shareholders, management and employees of privately-owned businesses.
So why is the adoption of ESOPs in the United States still so much lower than what most experts would expect — making these powerful structures so underutilized?
Most industry pundits point to an ESOP reputation hangover created by weak companies misusing them in the past, along with a fundamental misunderstanding of the complex workings of ESOPs.
We’re here to help clear that up.
We take a closer look at the optimum makeup of an ESOP-ready company, unpack the collective benefits for all ESOP stakeholders and provide best practices for implementing an ESOP — all with the objective to help you adopt what we think is a powerful business-enhancing tool.
What an ESOP-Ready Company Looks Like
Whether it is a newly formed private-equity venture, manufacturing business, engineering firm or mature family-run enterprise, ESOP integration is not conditioned by the age of the business and can be created at any time in its lifecycle. Instead, the relevant characteristics of a business that may be ready to consider an ESOP in its retirement portfolio include:
- A desire for ownership diversification and wealth creation.
- A financially healthy business that is profitable and growing is best suited to implement an ESOP.
- An ownership group not reluctant to allow additional stakeholders, their employees, to share in the company’s equity.
As with every company, its corporate makeup and financial situation is distinct. Individual business valuations are critical in determining whether the inclusion of an ESOP is the right step for a given business. An ESOP cannot save a highly indebted business or one with a weak business model, but it can be a powerful tool for companies that exhibit the above qualities.
The Collective Benefits of an ESOP
When properly implemented, ESOPs can have tremendous benefits for business owners, employees and the company. They can be used to foster employee engagement, as a means of liquidity, as a succession planning strategy and more:
- Create Wealth: The government provides significant tax incentives for businesses to create ESOPs. For ESOP participants, most studies show that these plans outperform the S&P 500 in year-over-year investment returns and outpace 401(k) plans as a source of retirement income. These benefits can offer significant wealth creation for shareholders, management and employees.
- Engage Employees: ESOPs provide employees with a direct stake in the company’s success, thus helping to increase employee engagement and performance.
- Provide Liquidity: As an alternative to a traditional acquisition or private-equity funding, ESOPs create liquidity for shareholders by selling the business or parts of it to employees at competitive valuation and, in some cases, at significant tax savings to the sellers. These transactions can be financed by outsiders or by sellers, creating multiple means of liquidity.
- Protect Income and Assets: Qualified as a retirement plan, ESOPs are protected assets under the Employee Retirement Income Security Act of 1974 (ERISA), meaning that as cash is distributed from the business to the ESOP, such cash distributions are safeguarded in the event of bankruptcy.
- Diversify Ownership: Unlike private-equity transactions, ESOPs create an opportunity to diversify the ownership of closely held businesses without giving up operational control.
- Provide Stability: As a means of succession planning, ESOPs provide corporate stability through major leadership transitions.
Best Practices for Creating an ESOP
Best practices for ESOP implementation include:
- Perform a Preliminary Feasibility Study: The first step in creating an ESOP is to hire an advisor to perform a feasibility study. This step will help determine whether the company’s financial profile and demographics match an ESOP’s needs (e.g., business earnings, debt capacity, consistent and long-term workforce, supportive leadership). More importantly, the goal of this step is to discuss a business value that shareholders would entertain. If the answer is no, the process ends here.
- Hire a Legal Advisor: The legal advisor will advise the company on the ESOP legal rules and steps required to execute an ESOP.
- Select a Trustee: The trustee of an ESOP is generally an independent fiduciary who would represent the ESOP participants. This generally avoids a conflict of interest with management or current business owners. In the capacity of trustee, this individual is generally responsible for hiring a valuation firm and legal advisor specifically for the ESOP.
- Establish Plan Parameters: In this step, the trustee and the seller negotiate the final valuation and plan design. The key is to not have an excessive valuation that puts too much debt/strain on the business and its ability to succeed moving forward.
- Plan Implementation: This covers the execution of the ESOP, employee communications, IRS plan approval, corporate governance, executive compensation and the ongoing administration of the plan.
Contact Us
ESOPs provide compelling benefits to management, employees and the company alike. We hope this information motivates you to consider an ESOP and provides enough information to help you implement one for your company. You don’t have to take this step alone.
The Employee Benefits Practice at PKF O’Connor Davies can assist companies and business owners with ESOP transactions, including the financial, plan design, feasibility analysis, succession planning, tax, accounting, employee benefit transformation services and executive compensations analysis. To explore your options, please contact the partner in charge of your account or:
Timothy J. Desmond, CPA
Partner
tdesmond@pkfod.com | 551.249.1728
John N. Vitucci, CPA
Partner
jvitucci@pkfod.com | 917.841.8718