We have received several inquiries over the last few months about ESOP’s (Employee Stock Ownership Plans). In light of that, I thought it would be a good time to provide a brief overview of how ESOP’s are structured, how they work, and the things you need to consider and handle correctly to be successful.
How Does An ESOP Work?
There are three general steps to establishing an operating and ESOP:
Evaluating the transaction and the feasibility of an ESOP for your company
- A feasibility analysis should be conducted with qualified advisors who have experience with ESOP transactions. This includes:
- A financial analysis to determine the viability of an ESOP transaction;
- A business valuation should be completed;
- You should evaluate your leadership depth and breadth. Companies that are heavily dependent on the owner or a small group of key employees may want to implement a management development program prior to entering into an evaluation of an ESOP since employees will become beneficial owners;
- Management style should be evaluated. Similar to leadership depth, if a very strong owner or manager is in place and cannot or will not be comfortable with sharing some decision making and control, it may be best to either resolve that issue or avoid the ESOP option;
- Examine the options that are available for funding an ESOP transaction;
- Putting a plan in place for staging and ESOP installation.
- Put the right advisor team in place
- Legal advisor experienced in ESOP’s
- Financial advisor experienced in ESOP’s
- CPA advisor experienced in ESOP’s
- Determine who will be trustee for the ESOP
- Understand how ESOP’s work
- ESOP’s are much like 401k plans in their operation
- One difference from a 401k plan is the requirement of an annual valuation of the company
- There are significant compliance issues that must be managed by a qualified advisor
- These compliance issues will come under intense testing. Testing processes by government agencies are increasing in intensity and frequency.
- An ESOP, like a 401K plan is exempt from income tax so long as it is in compliance laws
- You can probably imagine the reaction of your employees participating in an ESOP if they suddenly found that it was not in compliance and they got a large tax bill
- Successful ESOP’s employ extensive communication processes with participants to maximize the benefits that are available in an ESOP. Failure to execute on this is often at the core of unsuccessful ESOP’s.
What Are the General Qualifications for A Successful and Sustainable ESOP?
- Scale of the Business
- There are no size requirements to establish and ESOP
- Gross revenue and profitability do not matter
- A company must have ten or more employees to qualify for ESOP status
- Most successful ESOP’s have twenty or more employees but you can succeed with less
- Industry Characteristics
- There are no industries that do not qualify
- The characteristics of the individual company are more important
- Most heavy concentration of ESOP’s are in manufacturing, wholesale, construction, general services (think architects)
- Cyclical industries with variable profits make ESOP operations more difficult
- Businesses with high employee turnover are not good candidates for ESOP’s until measures have been taken to reduce turnover problems
- Strong management team is required to handle complexity of operating an ESOP and keep confidence of employees
- Company must be able to operate without a single owner or key manager
- There should be provable prospects for growth and sustainable revenues
- Tolerance for Complexity
- An ESOP will add complexity both in the establishment and ongoing operations of the company;
- Governance will be more complex
- An ESOP involves the addition of a trustee for the ESOP. This trustee will have governance rights.
- Much of complexity in operating an ESOP is in the establishment of the ESOP plan
- There can be considerable complexity in other forms of ownership transitions as well;
- There will be compliance issues that will add complexity which your current ownership and management team must be prepared and willing to handle
- It is Critical to Have an Experienced Team of Advisors With Experience and Expertise
- This may be the single biggest factor to the success of an ESOP
- Do not assume that your current advisors (internal or external) have the needed expertise
- Administration costs can be similar to that of a 401K if the proper team is in place
I will continue this discussion on ESOP’s next week.
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