Employee Ownership: Is an ESOP Right for Your Company?
The Benefits of ESOPs
“ESOPs can be a great way to help incentivize employees through participation of company ownership, with potentially no out of pocket costs to the employees, while also creating a market for private company stock,” says Mills Snell, a partner at Pendleton Street Advisors, a business advisory firm dedicated to helping owners transition their business.
For a business owner, being able to avoid or defer capital-gain taxes is another major benefit. “Strong tax incentives that help moderate large capital gains tax consequences help steer many founders and entrepreneurs towards ESOPs,” explains Mills. Loren Rodgers, the Executive Director of the National Center for Employee Ownership, says that ESOPs are unique in how they allow organizations to borrow money. “The ESOP borrows cash, which it uses to buy company shares or shares from existing owners. The company then makes tax-deductible contributions to the ESOP to repay the loan, meaning both principal and interest are deductible.”
Enhancing Company Culture
Kris Maynard, Chairman and CEO of Essential Ingredients, a private company that distributes chemicals for the personal care, household and industrial cleaner, cosmetic, and other industries, recently implemented an ESOP program. Kris shares that implementing an ESOP was appealing because of the opportunity to enhance his company’s culture. “For me and my partners, an ESOP was the best option for us as it was the only way we could ensure that our culture and our people would survive an ownership transition,” he says.
“We had been approached by many Private Equity Groups and competitors to buy the company and many of them promised that they would keep our culture/staff in place, but we knew that once we sold, things change and there would be nothing we could do to prevent them from doing what they needed to do to meet their goals, which are heavily profit motivated.”
Kris says that management recognized the need for a profitable and sustainable business, but that they were also committed to supporting culture and staff for the long-term. “There are certainly short-term measures folks can take to boost profits…but these are not sustainable options for a solid business. The ESOP route allowed us to transition the business over time to the people who helped us build the business, and ensure that our culture was magnified in the process by rewarding every employee with a degree of ownership.”
Essential Ingredients' story is common. Loren says that many ESOP companies find that the payoff to engaging the workforce is even higher for them than for other companies. "Everyone wants informed, engaged, innovative employees," says Loren, "but the data show that all of those practices are especially effective in employee-owned companies. There's a synergistic effect between employee-ownership and engagement." He cites data showing the employee owned companies with high levels of employee engagement have higher rates of sales growth, employment growth, and productivity, as well as lower turnover.
"It just makes sense. When employees benefit from making the company stronger by owning shares, they have a reason to be better stewards of the company's success."
“Not a Silver Bullet”
Tax benefits are a major advantage of ESOPs, but Mills warns that ESOPs must be carried out very carefully to ensure that costs are mitigated, and strict ERISA regulations are adhered to. “While an ESOP can create liquidity for an owner that is otherwise heavily concentrated in the business, it can also potentially defer an owner’s overall timeline for exiting the company because either they, or the ESOP, will substantially guarantee the liabilities associated with the change in ownership- either through bank financing or the owner holding a seller’s note.”
Loren says that the results of a 2015 survey of ESOP transactions showed that more than two-thirds of the transactions used a loan, sometimes from an outsider, sometimes seller-financed, and often both. The survey also shows that transactions are getting more expensive, in part, he thinks, because companies are conforming to new expectations from the Department of Labor. Before 2013, 23 percent of transactions reported in the survey had costs more than $200,000, while 32 percent transactions in or after 2013 cost that much, he says.
If an owner is looking to be financially independent from the business, they should know that it is a long process—one that can take years. The company will often need to take on debt in order to begin the ESOP, and a thorough analysis must be conducted to ensure that the company can sustain the debt associated with that level of recapitalization. “This analysis would also help [an owner] look ahead to make sure that the ESOP and company can afford to buy out employees as they retire and need to turn their stock into cash. This is an often overlooked detail, but it is crucial since many companies have a workforce that will retire in waves and could create cash crunches,” explains Mills.
“A common misconception about ESOPs is that they are a silver bullet, of sorts. Again, ESOPs can be an effective tool, but owners must be careful to not assume that it is a ‘one size fits all’ tool.”
Mills emphasizes that choosing an ESOP is a significantly longer-term process than selling the business to an outside buyer. “Owners must understand that they will be involved and even on the hook for several more years, so depending on their succession goals and plans, this should be considered.”
A Good Fit For Your Company?
An ESOP may be a good fit for an owner that wants to stay involved in the business for quite some time. It also keeps owners financially tied to the business for several years. “The owner should not be looking for a quick sale or a way to completely remove themselves from the business. They also are typically thinking about employee engagement and participation in the business long before they are contemplating their own retirement. If an owner isn’t sharing financial information, key decision making, and some strategic direction with employees to start with, then an ESOP is going to be a big change, all at one time,” says Mills.
Kris also believes founders or owners need to consider the motivation for adopting an ESOP. “A business owner will most likely get a higher price for the sale from an outside buyer and implementing an ESOP is expensive and time consuming—about 1.5 percent of deal value in expenses, in our case.” Kris says the motivation can include protecting and enhancing the culture, rewarding the employees, and providing a path forward for a longer term passing of the baton.
Take Advantage of Your Advisors
If and when a company is interested, having well qualified advisors in the process is critical. “Many folks will try to pinch pennies in the process, but from what I have heard, you will pay up front for quality or on the back-end in potential penalties with the Department of Labor, so my advice is to select a solid group of advisors to walk down the path with you.”
An ESOP is one option for some businesses, but it is not the only option or only way to transition a business or to evolve ownership of the business. “After taking a look at all your options, it is important to get unbiased advice about the feasibility of and ESOP for one’s specific set of circumstances,” Mills says.
“Make sure that you understand the incentives your advisor has, and if possible, talk to someone who understands ESOPs, but has more than one tool in their tool belt when it comes to business succession planning.”