All-in-One Financial Tool: The ESOP
I bought my boyfriend a multi-tool, hatchet thing-a-ma-bob for Christmas. It’s an ax, a hammer, a three-bit screwdriver, a pocketknife, a can opener, and a bunch of other things all in one compact tool. But, it’s still in the box. I’m not sure he appreciates it. Maybe it’s because it’s new and he’s old. Or he just likes doing things the way he’s always done them. Maybe he doesn’t get all the things it’s capable of. But when I saw it on the shelf, all I saw was power and efficiency. Just like the incredible financial tool known as an ESOP, because man, this thing can do it all!
Employee Stock Ownership Plan
Want to take some money off the table with a liquidity event? Look into an ESOP.
Leaning more towards a complete exit? ESOP.
Spending a fortune on taxes? Try an ESOP.
Want your employees to truly be part of the wealth generation process they’ve helped you build? ESOP.
Looking for financing that won’t break the bank? Take a peek at the ESOP.
Contemplating a business acquisition, either as a standalone or as part of a rollup structure? I know, broken record, but an ESOP might be the right tool for this job, too.
So what is an ESOP anyway? For that beautiful but complex answer, Ron sat down with expert Larry Kaplan, founder and managing partner of CSG Partners out of New York City. He says, in a nutshell, an ESOP is a plan “where the government provides tax incentives to business owners in order to get them to sell their companies to their employees, rather than selling out to a strategic buyer or financial buyer… [in order to] get equity ownership in the hands of the workers.” He also describes it as a “tax advantaged, leveraged buyout”.
In more formal terms, an ESOP is a non-discriminatory, tax-qualified employee benefit/retirement plan, born out of the 1974 Employee Retirement Income Security Act, affectionately referred to as ERISA. It’s a trust fund that owns shares in the company, for the benefit of the employees. The trust is set up and funded by the company. It can be paired with a 401K plan or stand alone. It’s the most powerful way for employees to enjoy the fruits of their labors through company ownership and it provides a plethora of advantages for the original company owners. It’s like a friggin’ miracle! As a CPA, I’ve known about ESOPs for a while, but this info blew my socks off with the multitude of ways it can be utilized, and how it can allow both owners and employees to create a new level of wealth.
It's a plan that is generally available to a S Corps, C corps and LLCs, though the rules and advantages vary amongst the different entity structures. Sorry partnerships, you’ll have to sit this one out. ESOPs can be utilized by businesses of varying sizes and by both private and public companies. Employees are represented by a trust and receive shares in relation to their salaries. The shares are held inside the retirement plan, allowing for growth on a tax-deferred basis. It usually involves a vesting schedule. The original owners get to defer, and sometimes skip right over, yes skip, paying taxes on their sale proceeds. Are you intrigued yet?
The Benefits
We’ll start with Corporate America’s underdogs, the employees.
The employee benefits begin with the fact that unlike a 401K plan, ESOP contributions do not come from the employees’ pockets. The company typically funds the account.
Like a 401K, and other standard retirement plans, ESOPs grow on a tax-deferred basis, keeping all the dollars working until distributions begin.
ESOP employee wealth generation is not a fantasy. According to a Rutgers study of low/moderate income workers participating in an ESOP, the median account value is $165,000. The typical American home in this income group has only $17,000 in retirement savings. Rutgers also found that low/moderate income participants ages 60 to 64 have 10 times more wealth than the average American in that same age range.
The ownership program also provides an increased level of employee morale and pride in their work. Punching a time clock feels so much better when you know you can impact the bottom line and your own net worth simultaneously.
As great as the benefits are for employees, the real magic happens for the company owners. The incentive for owners to transfer their company to their employees is huge. Kaplan explains it like this, “So if a business owner sells their stock to an employee, when they receive that cash, if they reinvest it under Section 1042 of the US code, which is investing into stocks and bonds of US operating companies, they pay zero tax…because you don't have to pay capital gains taxes when you sell to an ESOP. …You have to be a C Corporation to do that.”
Larry goes on to give us an example, “Say my company is worth $10 million, and I sold half of it to the employees for $5 million. The company receives $5 million of tax deductions that he could use to offset its income going forward. So assuming that company was a pass through entity, paying 43, 44 cents of every dollar in taxes, now it's going to hopefully be paying zero in taxes for many years. So those are the two major tax deductions, no capital gains taxes to the shareholder, and then the company receives tax deductions to pay its debt down much faster.” Most ESOPs are funded with debt, but that’s the beauty of it. The employees don’t have to have money on hand to buy the stock.
Now you’re probably thinking you need to switch to a C Corp, right? Don’t give up your S election yet! S Corp ESOPs are, are you ready for it, tax-exempt entities! (At least to the extent of ESOP ownership.) You’ll find some examples of this in action later in the interview.
Another benefit is that once the decision is made, the ESOP transaction can happen quickly, meaning liquidity happens fast as well. This allows the owner to take some chips off the table, while still playing an active role in the company. Or, that liquidity can be a financing source for capital improvements, refinancing debt, or even growth through acquisition.
The Pitfalls
Every job done is done “better” with the right tools, but those tools always come at a cost. The table saw is much better for a big construction project than a hand saw, but the table saw is more likely to cut your hand right off. Plus, it’s much more expensive to buy. The ESOP is no exception.
Both the initial implementation costs, which can be a staggering $300K for large companies, and ongoing compliance and regulatory fees, can certainly be prohibitive. Obviously, the tax savings must be weighed against these costs.
If getting top dollar is your ultimate exit goal, then an ESOP may not be for you. An ESOP valuation will most likely result in a lower price tag than you could get from private equity or a strategic buyer.
The complexity and lack of flexibility for the original owner can also be a problem. It’s prompted some companies to forgo the tax advantages of an ESOP and create their own customized employee ownership program. As ownership is transferred to the plan, the original owner will be giving up more and more control over the thing that has probably been their 110% focus for the last few decades. If they sell more than 50%, but less than 100%, the owner may no longer be able to steer the ship or prevent the company from taking unnecessary risks.
And speaking of risks, the lack of a strong management team with the leadership skills to carry the company into its next round of success is probably the biggest risk of selling your company to your team.
The opposite can be true as well. If the original owner remains at the helm, and he or she has been running the business in a loose-goosey fashion, with sloppy books and poor valuations, lawsuits are sure to follow. As mentioned earlier, the ESOP is a trust. It must be run for the benefit of the employees. The fiduciary duty of the trustee is serious business and comes with regulatory responsibilities and risks, including the risk of an employee lawsuit.
Owners often implement a high degree of leverage to fund the plan, and therefore, their own exit, leaving the company with large amounts of debt and the inherent risk that goes with it. It’s common practice to sell out to the ESOP over time, and as with any time-based payments, there will always be the risk of running out of the cash needed to make future payments.
Potential pitfalls exist for employees as well. They often don’t get to participate in the day-to-day management of the company as intended. Or the education to do so responsibly isn’t provided. Look up the United Airlines ESOP from 1995 for a high-profile ESOP horror story. Yikes! Studies have shown that true employee participation, including education, can increase the growth of ESOP companies by as much as three to four times over ESOP companies that leave employees out of managerial tasks.
On top of this, ESOP employees often end up with an unbalanced retirement portfolio, much too heavily weighted in their own company stock with little to no diversification. If the company were to fail, both their job and their retirement savings will be down the drain. United proved this point all too well.
As great as they can be, ESOPs aren’t going to work in every situation. So who are the best candidates for Employee Stock Ownership Plans? The companies that have the most success will have a strong management team in place, a team that extends beyond the owner. They will have at least 40 employees and will have strong, consistent financials. Most importantly, the owner must be prepared to give up control of their baby.
ESOP implementation and use cases coming next.
Let’s get wealthy--with ESOPs!
(A special thank you to Ronald Skelton and his interview of Larry Kalpan;-)
