When Is a Privately Held Business ESOP-Ready?

John Vitucci is a principal and Timothy Desmond is a partner at O’Connor Davies, a certified public accounting firm with offices in New York, New Jersey, Connecticut and Maryland. Both are members of the firm’s employee benefits practice.

An employee stock ownership plan (ESOP) can provide significant benefits to shareholders, management and employees of a privately owned business.

ESOPs provide businesses with financial liquidity and can be an alternative for business owners who might otherwise consider selling their company to a third party, such as a private equity group. ESOPs also provide employees with an ownership interest in the company they work for, and stock holdings that can grow into a valuable retirement benefit.

The government provides significant tax incentives for businesses to create ESOPs. Most studies show that asset growth in these plans outpace 401(k)s, and thus ESOPs can substantially augment participants’ retirement incomes. Given those factors, it's no surprise that the total number of ESOPs—and the number of employees they cover—has grown over the last decade, and that there are currently more than 10,000 ESOPs in the U.S.

Yet despite this recent upward trend, the number of ESOPs is still far below what it should be, according to most experts. Many industry pundits point to a lack of understanding of the complex workings of ESOPs as a chief reason these plans have not been more widely adopted as a profit-sharing tool.

The Benefits of Providing an ESOP

On the plus side of the ESOP ledger, employers should consider the following benefits:

• Wealth creation. The tax benefits can offer significant wealth creation for shareholders, management and employees.
• Greater employee engagement. By providing employees with a direct stake in the company’s success, ESOPs increase employee engagement and performance.
• 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.
• Income/asset protection. Qualified as a retirement plan, an ESOP is a protected asset under the Employee Retirement Income Security Act, meaning that, as cash is distributed from the business to the ESOP, these distributions are safeguarded in the event of bankruptcy.
• Ownership diversification. Unlike private equity transactions, an ESOP creates an opportunity to diversify the ownership of a closely held business without giving up operational control.
• Stability. As a means of succession planning, ESOPs provide corporate stability through major leadership transitions.

When to Consider an ESOP

An ESOP can be created at any time in the life cycle of a business. Whether it is a newly formed private equity venture, a manufacturing business, an engineering firm or a mature family-run enterprise, ESOP integration is not conditioned by a business’s age.

Instead, the relevant characteristics of a business that may be ready to include an ESOP in its retirement portfolio include:

• Desire for ownership diversification and wealth creation.
• A growing, profitable business (as a financially healthy business is best suited to implement an ESOP).
• An ownership group that is not reluctant to allow additional stakeholders—their employees—to share in the company’s equity.

Every company’s corporate makeup and financial situation is distinct, so individual business valuations are critical in determining whether or not 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 poor business model, but it can be a powerful tool for a company that exhibits the above qualities.

How to Create an ESOP

Best practices for ESOP implementation include:

• Perform a preliminary feasibility study. The first step in creating an ESOP is to perform a feasibility study. This step will help determine whether the company’s financial profile and demographics match an ESOP’s needs (business earnings, debt capacity, a consistent and long-term workforce, supportive leadership). More importantly, the goal of this step is to discuss whether there is sufficient business value to appeal to shareholders. 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 the steps required to execute an ESOP.
• Select a trustee. The trustee of an ESOP is generally an independent fiduciary who represents the ESOP participants. This generally prevents a conflict of interest with management or current business owners. As a trustee, this individual is generally responsible for hiring the ESOP’s valuation firm and the ESOP’s own legal advisor.
• Set up plan parameters. The trustee and the seller negotiate the final valuation and the plan design. The key is to not have an excessive valuation that puts too much debt and financial strain on the business and its ability to succeed going forward.
• Implement the plan. This is the execution of the ESOP, and involves obtaining IRS plan approval, setting up corporate governance for the ongoing administration of the plan, and using employee communications to promote its use and foster greater engagement, now that workers have the opportunity to become stockholders.

Related News Articles:

Why Advisory Firms Need an Employee Ownership Plan, On Wall Street, November 2015

IRS: Prototype ESOP Documents Now Allowed, Morgan Lewis, October 2015

Related SHRM Articles:

• ESOP Fiduciaries Face New Legal Landscape, HR Magazine, September 2014
• Sprucing Up Employee Stock Purchase Plans, SHRM Online Benefits, July 2013
  
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