The Pros and Cons of ESOPs: Weighing Your Options

When it comes to choosing an ownership transition strategy, owners of closed businesses have a lot to think about. What transition options are available? And which of these options fit well with the goals of both the owner and the business? Clear and convincing answers to these questions can be elusive.

From our experience, we know that exit options may include a sale to a third party, a management buyout (MBO), transition to family, or an Employee Stock Ownership Plan (ESOP). For many business owners, an ESOP can be an attractive alternative to these options. A host of factors will influence which option is best for each homeowner’s unique situation, but for those seriously considering an ESOP, it’s important to start with a basic understanding of the pros and cons of an ESOP.

What is an ESOP?

An ESOP is a qualified employee benefit plan that provides an internal transition of ownership with financial rewards for the business owner and employees. In many ways, an ESOP is similar to a profit sharing plan. Generally, an ESOP trust is established to purchase shares of the company in question. Subsequently, the shares are assigned to the individual accounts of the employees. This assignment may be based on your compensation levels, length of service, or some other formula. An vesting schedule can be used so that as employees accumulate seniority, they become increasingly vested in their accounts.

In particular, the ESOP trust can borrow money to facilitate the purchase of company shares. This loan can be repaid by contributions or distributions that the ESOP receives from the company.

The professionals

An ESOP can help ensure business continuity, which is important to many owners who have worked so hard for so many years to grow their businesses. An ESOP is scalable over time and offers a high degree of flexibility and benefits, some of which are outlined below.

• For a business owner, an ESOP allows for more internal control over the transaction and can take less time to implement compared to an outside sale.
• With an ESOP, the business owner can decide whether to sell the entire property or instead transfer ownership gradually over time. Using an ESOP to create liquidity for a minority interest does not prevent an owner from selling the business to a third party in the future.
• ESOPs can help business owners gradually begin the process of turning their private property into liquid, diversified capital.
• An ESOP is a powerful way to give employees the company and boost morale. The opportunity to participate in the growth and performance of the company gives employees a sense of ownership, with the potential to strengthen their contribution to the success of the business.
• Finally, there can be a number of attractive tax and investment benefits with an ESOP. For example, the principal amount of an ESOP loan may be tax deductible, so the business may repay a loan used to finance the ESOP transaction with pre-tax dollars. A selling shareholder may elect Section 1042 tax deferral treatment and may indefinitely defer capital gains taxes associated with the sale of his shares, by meeting certain requirements. Finally, for businesses that elect S-Corp status, the ESOP’s share of recognized profits is generally exempt from income taxes.

The cons

Although there are numerous benefits to an ESOP, they require the assistance of professionals with an understanding of a unique mix of fields, such as business valuation, transaction dynamics, tax law, ERISA compliance, and more. Even the perceived complexity of an ESOP can be a deterrent when deciding whether or not to implement an ESOP. Other detractors may include the following:

• Current shareholders are unlikely to maximize proceeds from a sale to an ESOP, as the ESOP is a financial buyer, not a strategic buyer. The ESOP can pay up to full fair market value, but no more, while a strategic buyer can pay more.
• If you sell 100% of the company, outside lenders may not be willing to finance the full purchase price of the company’s stock, which may require seller financing to cover the balance. An ESOP requires ongoing administrative costs, including the annual appraisal, plan administration, legal and possibly trustee fees.

Proper orientation is key

ESOPs can be a very effective ownership transition tool with a host of benefits for business owners. Very often, the fiscal, financial, and cultural advantages far outweigh the effort and cost of implementation. Hiring experienced professionals to review all transition options should be the first step for business owners to make an informed ownership transition decision that will leave them happy now and in the long run.