An employee stock ownership plan (ESOP) can be a useful tool for meeting a wide array of business goals for nonpublicly traded companies, but they can intimidate even the savviest business owner. That shouldn’t be the case. With the right guidance from the right advisors, understanding ESOPs, and whether an ESOP is the right way to achieve personal and business goals, should be simple.
This 4-part primer on ESOPs will help get you there. Part 2 discusses how to determine if an ESOP is right for you. Part 3 looks at ESOP’s tax benefits. Part 4 discusses how many shares the owner should sell to the ESOP.
We begin here with the basics.
What ESOPs Do
All ESOPs give employees the opportunity to obtain stock in their company. How they accomplish that, and which employees benefit, varies based on many factors, especially the overall goal of the business and its ownership.
ESOPs are tremendous retention tools because of the clear benefit they provide employees, and because they align the interests of employees, studies have shown that ESOPs generally boost the performance of a company.
ESOPs can provide smooth transitions of ownership, particularly in cases where succession planning is a challenge. A good ESOP plan can deliver liquidity to the selling shareholders while allowing them to make a planned transition away from managing the business, and/or remain as involved as they want, whether as a shareholder or manager.
How ESOPs Work
To implement an ESOP, the employer sets up a trust to hold stock in the corporation that’s either newly issued or purchased from the owner. If it’s buying from the owner, the trust will hold a cash contribution from the employer or loan proceeds to pay for the stock.
The company’s owner and the ESOP trustee will determine the amounts of stock and terms of the sale, but it must be based on a third-party appraisal of the company’s value. Upon agreement, the ESOP purchases the stock and holds it in the trust as an investment for the benefit of the ESOP participants.
Share Payment And Distribution
The ESOP often borrows some or all of the purchase price – this is known as a leveraged ESOP. Shares that are fully paid (meaning they’re paid for in cash or released from the reserve account as the ESOP makes payments on the loan) are allocated to participants. Participation will vary based on the company’s goals and needs, but must pass certain requirements that an ESOP advisor can help sort out.
As additional stock is allocated to participants’ accounts, the value of the account grows (assuming the stock value has not dropped). Similarly, as the value of the company’s stock increases, the value of the participant’s account increases.
ESOPs Are Flexible
Each year, the employer can choose whether to contribute additional newly issued stock to the ESOP and/or make a cash contribution. Contributed stock is allocated to participants as described above. If a cash contribution is made, a leveraged ESOP will use the cash to make a payment on its loan, which allows more shares to be paid for and allocated to participants. This process continues until all of the stock in the ESOP has been allocated to participants’ accounts. If the ESOP has not already purchased 100% of the company’s stock, the non-ESOP owner can always decide to sell additional shares to the ESOP if the owner and the ESOP trustee agree on terms.
As participants approach retirement age, they can request that the stock in their account be diversified into other investments. At retirement, the ESOP distributes cash or stock to the participant, depending on the plan design. If stock is distributed at retirement, it is usually restricted by a right and/or obligation of the company to buy it back when the retiree wants the cash.
Understanding ESOP’s basic structure really is that simple. Employee Benefits Law Group has been helping companies evaluate, create and manage ESOPs for dozens of years. Contact us to see if an ESOP can help you and your company become even more successful.
The National Center For Employee Ownership is another helpful source of information for those exploring ESOP.
Understanding If An ESOP Is Right For You
Our second blog post in this series outlines some questions you need to explore to help determine whether an ESOP is right for you and your company.