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Buying In: The pros, cons and pitfalls of ESOPs

Whether you are a veteran employee or the new kid on the block, businesses that offer Employee Stock Ownership Plans (ESOPs) are often more effective in attracting new talent and retaining long-term employees. The principle behind ESOPs is to give owners of a company a way to sell their business, or a portion of it, to their employees. In turn, the company provides employees with shares of ownership in the company.

As of 2015, there are an estimated 7,000 ESOPs covering about 13.5 million employees. “Any type of company in any industry can qualify for an ESOP. Two important points are the company is generating a profit and the owners want to sell,” says JB Henriksen, partner with Advanced CFO.

ESOPs provide incentives to employees to stick around and build the business while also providing an exit strategy for the owners. “ESOPs allow owners to sell their business to employees they know and trust and who built the company,” says Henriksen.

Advantages

One of the biggest advantages of ESOPs is they provide employees with personal ownership in the company.  Ownership can help businesses retain employees and improve their overall performance. “This sense of ownership helps companies hold on to their most valuable assets, their employees, and improve their performance because they are owners and personally vested in the company’s success,” says Jerry Vance, founder & managing partner of Preferred CFO.

Another advantage of ESOPs is the liquidity and exit strategy they provide for owners. Owners have the opportunity to sell their business and use the cash for other purposes. “They can sell the business to a trusted source, instead of selling it to a financial or strategic investor that may not share the same vision for the business,” Henriksen says.

There are also tax benefits associated with ESOPs. Companies arrive at a fair valuation of their stock price and employees get that price as their tax basis. Most contributions of stock and cash are tax deductible, as well as principal and interest contributions to repay a loan to the ESOP, according to Vance.  “An ESOP may also be set up to create a ready market for owners’ shares, where the shares of a departing owner may be purchased,” Vance says.

Additional tax benefits include the ability to defer or eliminate taxes from the gain on sale of stock by selling shareholders reinvesting in the business. “The ESOP is a non-tax paying shareholder and is considered an S corporation that is owned 100 percent by the ESOP and pays zero federal income tax,” says Richard Greene, partner with BDO Siedman.

Cons

ESOPs can also come with their fair share of risk. ESOPs can be expensive for companies to set up. They can cost in the range of $40,000 for a simple ESOP for smaller companies, and can be much more expensive for larger companies, according to Vance.

A valuation of employee’s shares must also be performed annually to determine the value of shares to be repurchased for departing employees. “When an employee leaves, you have to repurchase their shares, and this can a burden for the company if they are not in a position to do that,” explains Vance.

Perhaps the biggest con is that employees may not be the best owners. “The employees may not know how to manage the financial side of the business and how to best grow the business,” Henriksen says.

Last, companies often will not be able to put additional cash into the business to grow it. “The cash is being sucked out of the business for those employees to pay the owners,” Henriksen says.

Pitfalls

A common pitfall of ESOPs is that companies don’t plan their cash flow well enough.  Businesses often have a hard time securing funding to do what they need to do when they need to do it. “The company is using the cash being generated to pay the owners, and now the company runs out of cash and employees are now owners of a company that is out of cash,” says Henriksen.

People often think an ESOP is a way to save a struggling business and that is often not the case, according to Vance. “ESOPs are for companies that are doing well, have cash and are in a good financial position.”