ESOP is one way to fund succession
There are many ways to approach succession, including selling to outsiders, selling to insiders and merging. One of the more creative and planned approaches involves an Employee Stock Ownership Plan (ESOP).
An ESOP is one possibility you should explore early, as the decisions involve some sophisticated tax planning and organizational set-up.
ESOP 101
An ESOP is an employee benefit plan and, like other qualified plans, it is a trust that is a separate entity from the company. As with other retirement plans, the company makes annual contributions to the ESOP. Instead of investing the assets of the retirement plan in publicly traded securities, the ESOP buys stock in the company. Many times the ESOP buys this ownership interest by borrowing money from a bank.
The annual contributions made by the company are used to pay back the bank loan. As the stock is paid for, it is allocated to each of the plan participants based on a predetermined formula. The employees own part of the business through owning stock in the ESOP, cashing them out as they retire or leave the business.
Since the ESOP commonly buys its stock from the founding shareholders of the company, this creates cash for the original owners so they can leave the company or invest in other things.
ESOPs have trustees who are either from the company or who are professional external trustees. The ESOP trustees, just like any other shareholder of a company, get to vote on shareholder level decisions and help elect the board of directors.
ESOPs are subject to somewhat complicated tax and reporting regulations since they are retirement plans. They are rarely the first choice for financing a buy-out, since they are highly regulated and can be expensive, but have worked out well for certain types of firms, especially professional services firms.
Most business owners consider an ESOP for one of two compelling reasons. First, you may have a strong core group of employees you want to reward for contributions to the success of the company over the years. The “I want to give back” group of owners usually starts an ESOP earlier and continues to work for the company after the stock is transferred to the ESOP.
A company with this type of ESOP usually gains considerable and immediate buy-in from the employee and can attract and retain talented people more easily in competitive environments.
The second type of owner is looking for a way to finance the transition out of the business. This owner usually looks at an ESOP closer to his/her exit date. Using an ESOP as financing makes sense when you have a great group of internal managers with no access to capital to finance the purchase themselves.
Experts required
Because of their complex nature, you will need at least two experts to help you explore an ESOP: your certified public accountant, or CPA, and your attorney. Any succession plan should have both a financial plan and a management transition plan, and an ESOP is no exception.
Your CPA will need to help you determine the feasibility of an ESOP for your business, work with your bank, and explore the financial considerations. Your attorney will need to help set up the new ESOP and transfer the ownership correctly. As you go forward with the plan, you will also need an independent valuation expert and a plan administrator.
Most people look at other succession alternatives first. It is usually simpler and less expensive to sell your company to internal managers or external buyers than it is to set up and maintain an ESOP.
An ESOP must have an annual business valuation and has accounting and administrative fees. In order to contribute enough money to the ESOP to purchase stock from owners, you should have at least 50 employees to consider an ESOP – but 100 or more is better.
One of the best fits for an ESOP is a professional services firm. Because the people in the business are usually highly educated in their profession they tend to make a more cohesive group of owners. One of the less successful fits is a company that has a large number of lesser-skilled workers who may not understand the value or responsibilities of ownership.
An ESOP must be open to all employees, except those who are in a union. Like a profit-sharing plan, an ESOP lets all the employees share in the growth and profits of the company.
ESOPs and taxes
There are some real tax benefits to an ESOP. When the ESOP redeems, or buys back, the shares of someone who is retiring or leaving, this cost is tax-deductible to the company as a contribution to the ESOP. If a company paid to redeem shares outside an ESOP it would be paying with after-tax funds.
There is also the option of a Section 1042 tax deferral. If the ESOP will own more than 30 percent of the company, this lets the original owners sell their company shares to the ESOP and reinvest in blue chip stocks and bonds without paying capital gains tax until the new shares are sold.
This sophisticated strategy can save significantly on taxes and help retiring owners put more dollars into investments for a greater return.
If you are in “Day Two” or more of your company, the time to consider succession planning is now. Any sound plan, including an ESOP, takes time to consider your options, retain qualified advisers, set up the plan, groom new managers and create a smooth transition.
