Want to Sell Stock in Your Business But Keep Control? Consider an ESOP

In a closely held corporation, a time may come when the owner wants to sell stock in the company but still maintain control. This might occur, for example, when the owner plans to retire soon or simply seeks a way to raise capital. But an owner may be hard-pressed to find an outside investor. Selling stock to other shareholders may be an option, but in many cases the best way is to sell stock to employees through an employee stock ownership plan (ESOP).

4 Good Reasons To Offer an ESOP

ESOPs are the most commonly used form of broad-based employee ownership in the United States, according to the National Center for Employee Ownership (www.nceo.org). About 11,500 companies in all industries have ESOPs in place, though more than 25% of those are in the manufacturing sector. An ESOP provides several benefits not only to the owner, but to the company as a whole and, of course, to the employee participants. We’ll take a look at the disadvantages, but first, here’s a summary of an ESOP’s four main advantages:

1. Capital market. An ESOP creates a “friendly” market for a retiring owner’s shares – assuming the company has no interest in going public or being acquired.
2. Tax advantages. An ESOP offers substantial tax benefits – for example, the company’s ESOP contributions are largely tax-deductible. In some cases, an owner of at least 30% of the corporate stock can defer tax on capital gains.
3. Financing opportunities. An ESOP can borrow money to buy stock, and the company can make tax-deductible payments on the loan – providing an attractive form of debt financing.
4. Employee incentive. As an employee benefit, an ESOP can help attract and retain valuable employees. And when employees become owners, they profit from business growth, so they have an incentive to be more productive.

How ESOP Plans Work

An ESOP is a tax-qualified employee benefit plan in which most or all of the assets are invested in the employer’s stock. Funds and securities are held in trust and allocated to individual accounts for the benefit of employees and their beneficiaries. Like profit-sharing and 401(k) plans, an ESOP must include all full-time employees who meet specified requirements, often related to the number of years they’ve worked for the company. The company may allow broader participation in the plan – for example, part-timers who work at least 20 hours a week. The company may contribute stock directly to the ESOP, but more commonly it contributes funds the ESOP can use to buy shares, or else the ESOP borrows money to buy stock. Contributions are entirely or partly tax-deductible. As mentioned earlier, using the ESOP to borrow money offers significant additional tax advantages. That is why most companies with ESOPs use this method of debt financing.

You can set up an ESOP that gives participating employees either an equity interest or a controlling interest in the company. Different companies use different formulas to determine how many shares to allocate to each employee. For example, some base the number of shares on each employee’s relative yearly pay, so that highly paid workers receive more shares than low-wage workers. Others allocate an equal number of shares to all employees. And some use a combination of criteria that doesn’t discriminate on the basis of race, gender or other criteria.

Payback Time

Most ESOPs are set up so that employees gradually vest in their accounts. By law, vesting must be at least 20% per year. Employees typically can receive dividends on the stock each year they’re with the company. When participating employees retire, leave the company or die, they (or their estates) become direct owners of the vested shares in their accounts. The company must offer to buy back their shares at an appraised fair market value, so that employees are guaranteed a market for the stock.

Costs and Disadvantages

Setting up an ESOP is complex and expensive. And you have to spend money annually on appraisals and other professional services. Rarely is an ESOP cost-effective for a company with fewer than 20 employees, unless it expects to grow quickly. Another disadvantage is that some former employees might not sell their stock back to the company but instead hold it, allowing them to vote as shareholders. You have to decide whether you can live with that possibility.

Custom-Tailored Plan

The good news is that you have a wide range of options in setting up an ESOP, and you can tailor it to fit your needs and goals. If you decide to explore the idea of setting up an ESOP, or have questions about getting the most benefit from an existing plan, please call us.

Alternatives to an ESOP

An employee stock ownership plan (ESOP) is a great way to give employees ownership in a company, but it’s not necessarily the best plan for every company. Here are alternatives:

• Stock option plan. Stock options give key employees the right to buy shares at a fixed price (the grant price) when their options vest over a specific period in the future. The exercise term is commonly 10 years. If the stock price rises, the employees will exercise the option. If it falls, they’d have no reason to. Options work well for adequately capitalized fast-growth startups. You may offer options to as many or as few employees as you wish.
• Employee stock purchase plan (ESPP). This plan gives employees a chance to buy stock at a discounted price, usually through payroll deductions. Jaburg & Wilk, P.C.
• Section 401(k) plan. This popular qualified pension plan can be used in combination with your company stock. Employees contribute pretax dollars, and employers may make matching contributions. Like an ESOP, the company must include all full-time employees who meet minimum qualifications. Unlike an ESOP, a 401(k) can diversify its investments and offer participants a variety of choices, including company stock.
• KSOP. This combination of an ESOP and a 401(k) allows a company to match employee contributions with company stock.
• Phantom stock. This allows a company to reward key employees without giving up ownership. If the company then goes public or is bought out, owners of phantom stock receive a share of the proceeds.