One way for business owners to transition their ownership to their employees and to receive liquidity for their shares is through the creation of an employee stock ownership plan (ESOP). According to the National Center for Employee Ownership, there are almost 7,000 ESOPs with roughly 14.1 million participants in the United States. The industries in which ESOPs are most common include manufacturing, engineering, construction, and banking. The Seattle Times recently reported on a local company, Charter Construction, that chose this path. More than 100 companies in Washington give employees an ownership stake through an ESOP, including pet-supplies retailer Mud Bay, wholesaler Charlie’s Produce, Timberland Bank, engineering firm Hart Crowser, and even Boeing. So, what is an ESOP?

An ESOP is a type of tax-qualified retirement plan that is similar to a profit-sharing plan, except an ESOP must invest primarily in the common stock of the employer (or an entity that is closely related to the employer, such as a parent corporation). The plan’s acquisition of employer stock may be financed either by borrowing from the ESOP sponsor or the selling shareholders. In the alternative, the employer may contribute shares to the ESOP out of authorized but unissued shares. ESOPs are commonly used to provide a market for the shares of owners of closely held companies that are not yet marketable. This gives the owners an opportunity to develop a transition plan that allows the business to be sold at the pace most convenient for them, providing an alternative to a sudden exit and a great transition option for some business owners. At the same time, an ESOP can motivate and reward employees of the business by creating ownership opportunities and retirement assets.

Business owners can realize both tax and non-tax benefits from using an ESOP to exit their business. Shareholders of a C corporation who sell at least 30 percent of their stock to an ESOP can defer taxes on their capital gains from the sale of their shares. For S corporations, the percentage of ownership help by the ESOP is not subject to federal income tax. In addition, contributions by the corporation to repay the ESOP loan are tax-deductible, which means that ESOP financing can be accomplished with pre-tax dollars.

ESOPs also provide important non-tax benefits. Owners may wish to avoid a third-party acquisition that could result in the relocation of the business outside of the owner’s community or changes to the existing management structure. Owners also may want to reward employees who have made significant contributions to their company. When such employees become shareholders, they often feel an increased sense of connection with their company. A 2014 Employee Ownership Foundation research study found that 93 percent of respondents believed that the establishment of an ESOP was a sound business decision for their companies. 76 percent believed that the ESOP improved employee productivity, 70 percent found that it increased revenue, and 64 percent reported increased profitability. There can be clear advantages from both the owner and employee perspective.

In spite of all their potential advantages, ESOPs are not for every company and do not represent a “one size fits all” exit strategy. The valuation of company shares in connection with their acquisition by an ESOP must be supported by an independent, third-party appraisal, and may be lower than the value the selling shareholders could receive by selling the company outright or taking it public. An ESOP may only be used for C or S corporations, not partnerships or most professional corporations. Also, the expense of establishing an ESOP is more significant than the typical qualified retirement plan. For example, Charter Construction, which has over $70 million in revenue, reported that the expense of advisors and closing costs for the conversion added up to between $250,000 and $300,000. In addition to expenses associated with establishing the ESOP, the sponsoring employer will incur ongoing administrative expenses, including the annual expenses of an ESOP trustee and the costs of an annual valuation to determine an updated share value for ESOP administration purposes. Further, any future acquisition of an ESOP-owned company presents additional challenges because the ESOP trustee and other fiduciaries have a duty to determine that the purchase price is fair and the ESOP participants may have voting rights with respect to the transaction. These issues and others must be addressed when a business owner considers an ESOP conversion.

ESOPs are one among several exit strategies that business owners should be aware of, but they are not for everyone. While there are real benefits to converting a privately held company into an ESOP, there are also complications and drawbacks. In a later post, this blog will address how to establish an ESOP and what makes a company a good fit for an ESOP conversion.