As business owners approach the inevitable crossroads of exiting their companies, they are faced with a multitude of options. One compelling strategy that has gained popularity in recent years is the Employee Stock Ownership Plan (ESOP). ESOPs offer a unique path for business owners to transition out of their companies while providing employees with a stake in the business’s success.
In this blog, and in the spirit of Employee Ownership Month this October, we will explore how ESOPs work, the benefits and challenges they present to business owners, and how advisors should present ESOPs as an Exit Planning solution.
An Employee Stock Ownership Plan (ESOP) is a qualified retirement plan that effectively allows employees to become partial owners of the company. Here’s a simplified overview of how ESOPs typically work:
- Establishing the ESOP: After careful planning, a company establishes an ESOP trust, which holds shares of the company’s stock on behalf of employees. To fund the plan, shareholders either sell stock, contribute shares directly, or the company will contribute cash (which can be used to purchase shares)
- Employee Participation: Most full-time eligible employees participate in the ESOP. Certain exclusions can be made for union members and similar defined classes. Over time, employees accrue shares in the plan. They do not pay out-of-pocket for these allocations.
- Valuation: An independent appraiser determines the value of the company’s shares annually. This valuation process ensures that employees’ ESOP accounts reflect the fair market value of the shares they own.
- Employee Benefit: Share allocations vest over time, like a 410(k). Upon retirement or separation from the company, a participant’s vested shares are sold back to the company at a current valuation. They can pocket those gains or roll the proceeds into another qualified retirement plan.
Here’s more detailed information on how an ESOP works.
- Ownership Transition: ESOPs can provide an orderly and gradual transition of ownership, allowing business owners to step back while retaining equity and/or a leadership role with the company. Post-transaction, an employee-owned company’s board of directors maintains operational control. Companies remain independent.
- Tax Advantages: ESOP transactions can offer tax benefits to both the selling shareholder and the company itself. In many cases, a shareholder’s capital gains from selling equity to the ESOP can be deferred and potentially eliminated altogether. Companies can receive income tax deductions for contributions and can even become tax-free entities.
- Employee Engagement & Incentives: ESOPs can boost employee morale and productivity, as employees have a financial stake in the company’s success. This can lead to improved company performance and profitability. When employees gain a unique retirement benefit in the form of stock allocations, the employee-owned company as a whole tends to outperform their peers.
- Preservation of Legacy: Business owners who have poured their heart and soul into their company can use an ESOP to preserve their legacy and ensure the company’s continuation.
- Upside & Flexibility: Unlike most business transitions, ESOPs offer continuity of leadership and opportunities for shareholders to sell partial holders and get a second “bite at the apple.” An employee-owned company can also be sold to a third-party. Additionally, when ESOPs prosper, that upside is available to all stakeholders.
To learn more about upside potential and flexibility in ESOPs, watch the recent webinar recording hosted by David Blauzvern of CSG Partners.
- Complexity: Like an M&A transaction, ESOPs have unique intricacies. Business owners should fully appreciate the ESOP process, and will likely rely heavily on expert advice and professional guidance.
- Structured Transaction: Plan formations and ongoing management are regulated by the US Department of Labor, based on rules set by the IRS. As a result, a regimented transaction process and diligent plan oversight are necessary.
- Initial Cost: The expense of forming an ESOP can be on par with an M&A transaction. Legal, valuation, and trustee fees all contribute to the overall cost.
- Sale Price: A trustee cannot offer more than fair market value for company stock. That’s typically in line with what a financial buyer could pay. This might be seen as a negative to owners who believe they can get more by selling outright to a strategic buyer.
- Ongoing Commitment & Maintenance: If business owners don’t already have a strong management team in place, their continued engagement with the company may be necessary post-transaction. Further, since an ESOP is a ERISA-authorized qualified retirement plan, trustee oversight of plans and annual company valuations are required.
For professional advisors and business consultants, effectively presenting ESOPs as an Exit Planning solution requires a thorough understanding of the client’s goals and business dynamics. Here are some key steps to consider:
- Assessment: Begin by assessing the client’s business, financial situation, and long-term objectives. Determine whether an ESOP aligns with their ultimate goals.
- Education: Educate the client about ESOPs, explaining how they work, their benefits, and potential challenges. Provide case studies and examples to illustrate real-world applications.
- Valuation: Help the client understand the valuation process and how it impacts the ESOP transaction. Highlight the potential tax advantages of selling to an ESOP.
- Implementation: Map out a formal ESOP process with the client. Steps may include determining feasibility, selecting an optimal structure, securing third-party financing, engaging an independent trustee, establishing an the employee trust, negotiating a transaction, and finalizing plan documents. ESOP specialists may be needed for some, if not all these steps. With that in mind, assist the client in the selection of third-party professionals.
- Employee Communication: Assist with the plan rollout process and encourage ongoing communication with employees to ensure they understand the ESOP’s benefits and their role in the plan’s success.
- Long-Term Strategy: If the transaction does not represent a complete business exit for your client, work with them to develop a long-term strategy for the business post-ESOP, addressing their continued involvement and ultimately, their transition out.
How BEI ESOP Partners Can Help: CSG Partners
At BEI, we want advisors to be able to leverage your expertise, tools and industry partnerships to help their business owners thrive. Knowing that advisors appreciate the value of an extensive Exit Planning toolkit, we urge advisors interested in ESOPs as a planning solution to connect with our partners, including CSG Partners.
BEI supports CSG and their work in the ESOP market because they have guided hundreds of companies nationwide through the employee ownership process – from feasibility studies to financing and completed transactions. CSG Partners focuses on education geared towards advisors like you to help you honor and strengthen both your client-advisor relationship and your client’s perception of their Exit Planning experience.
If you are an advisor looking to adopt ESOPs to your toolkit, get connected with CSG Partners in a variety of ways:
- Listen to a recent presentation by CSG Partners Vice President, David Blauzvern, titled, “ESOPs: When Flexibility and Upside Matter Most,” linked HERE.
- Tune in for a short interview of David Blauzvern on BEI’s Why We Plan podcast.
- Schedule a meeting directly with CSG HERE.
Employee stock ownership plans (ESOPs) offer a compelling Exit Planning solution for business owners looking to transition out of their companies while preserving their legacy and providing employees with a stake in the company’s success. By understanding how ESOPs work, recognizing their benefits and challenges, and presenting them effectively to clients, advisors can help business owners make informed decisions about their exit strategy, ultimately contributing to successful transitions and continued business prosperity.