ESOPs Make Sense Only in Certain Situations
Executive Roundtable is a weekly column by TEC Worldwide, an international organization of more than 7,000 business owners, company presidents and chief executives. TEC members meet in small peer groups to share their business experiences and help one another solve problems in a round-table session. The following question and answer are a summary of a discussion at a recent TEC meeting in Southern California.
Question: I’m thinking about selling my business three to five years down the road and may want to explore an ESOP as one exit alternative. What are the pros and cons to this approach?
Answer: ESOPs (employee stock ownership plans) involve highly complex transactions and should be entered into with great care and deliberation. But in the right situations they offer significant benefits to business owners and employees.
According to Marty Mayer, president of SCS Management, a San Diego-based consulting firm that helps owners of middle-market companies create and implement exit strategies, ESOPs offer owners three major benefits: You can sell part or all of the company to your employees without paying any taxes; you maintain 100% control of the stock; you get a corporate tax deduction for the amount you get paid for the stock. In addition, dividends paid on stock held by the plan can be tax deductible.
For employees, such stock plans make it possible to reap some of the financial rewards of ownership.
The ESOP forms a trust that holds the stock the owner sells. During his or her term of employment, every employee maintains an account in the trust.
When employees leave or retire, their shares are redeemed for cash by the company or by the plan itself.
The downsides? The complex nature of ESOPs requires the services of experienced specialists at every step of the way. As a result, they cost a lot to set up and administer. Because they are covered by Employee Retirement Income Security Act reporting rules (similar to those in 401[k] and pension plans), ESOPs also incur ongoing maintenance costs such as an annual valuation and administration expenses. This requires that the company have sufficient cash flow to pay for these expenses.
In addition, Mayer said, ESOPs work well only in certain narrowly defined situations: when you want to leave the business to your children or your employees while simultaneously funding your retirement; if you need to buy out a spouse or partner who wants to leave the business; if you want to put ownership in the hands of your management team while locking them in with golden handcuffs; or if you want to take money off the table while maintaining majority ownership.
Employee stock ownership plans also can serve certain estate planning purposes. For example, suppose you have two children but only one wants to work in the company after you leave.
An ESOP allows you to pull money out of the company, invest it in something else and leave those assets to the child who doesn’t want to work in the business.
“Generally speaking, ESOPs don’t make sense unless you sell at least a third of the company,” Mayer said. “Otherwise, it costs too much, you don’t pull enough money out of the company to make it worth your while, and you create an ongoing entity that requires you to report to the IRS every year.
“If you decide to go forward, hire experts who specialize in ESOPs and get a professional valuation of your business. Above all, make sure you have enough free cash flow to finance the transaction. Otherwise, your ESOP stands little chance of achieving its intended goals.”
*
If there is a business issue you would like addressed in this column, contact TEC at (800) 274-2367, Ext. 3177. To learn more about TEC, visit www.teconline.com.
