ESOP Challenges

On numerous occasions, retiring business owners have raised the question, if an ESOP (Employee Stock Ownership Plan) as a means of transferring their business would not be better than selling the business to an investor?

Not surprisingly, that question is usually asked with the perception that an ESOP is “easy” to be executed, it will “do good” for the employees, and it can hide operational deficiencies in the company’s performance (that the owner does not want to tackle himself).

ESOPs have existed since the early 1970’s, and by one estimate there are more than 7,000 active plans today with 15+ million participants. The purpose of ESOPs is to create a transfer mechanism for the retiring owner of a closely held company, to utilize tax incentives by borrowing money for acquiring new assets in pretax dollars, and/or to reward (and motivate) employees.

How is this accomplished?  A company creates a trust fund/plan (ESOP) contributing new company shares/stock – or more often cash to buy existing shares, with such contributions to the trust being tax-deductible to certain limits.  More often, though, an ESOP is leveraged:  money is borrowed from a bank to buy a company’s existing shares from the retiring owner at a Fair Market Value, whereas the company’s future profits result in cash contributions to the ESOP plan enabling it to repay the borrowed funds.

The ESOP shares are usually allocated to individual employees either relative to their pay or some other more equal formula. With increasing seniority, employees are ‘vesting’ rights to the shares – often 100% vested within a three to six year time frame. Upon employee termination or resignation, the company buys back the stock from the employee at fair market value, subject to an annual outside valuation.

However, by simply creating an ESOP and contributing cash or company stock, the parting business owner looking to ‘sell’, rather than to give away his company, accomplishes little – other than the tax deduction the company receives for its contributions.

And here is where the challenges start: first, the loan for the newly created ESOP needs to be guaranteed to the bank. Short of the underlying company having had a very consistent and stable performance over the years with significant cash flows to service the loan, the bank will seek a loan guarantee from the retiring business owner. In short, the business owner will no longer manage the company and will no longer make key decisions, but will continue to guarantee the loan. Not a desirable position to be in! (And this sets aside that banks are already leery to support transfer structures where employees assume responsibilities of management).

Further, ESOP costs are substantial – not only in its initial creation but also with continued maintenance due to proper third-party administration, legal costs, trustees’ meetings and annual valuation expenses.  Such additional expenses might very well overburden small or mid-sized companies.

Additionally, and potentially most significant, the trust needs to be constantly prepared to buy back parting employees’ stock, requiring substantial cash holdings on the part of the trust – a factor with a particular negative impact during a recession with potential lay-offs when companies typically have little cash to begin with.

In sum, with few situations where an ESOP truly makes sense, owners of privately held mid-sized businesses generally are in a much better position when selling their business to a third party investor – it will not only maximize the receipts for the seller in a competitive environment, it will also disconnect a business owner from substantial loan guarantees post closing.