As baby boomer business owners age, there is a pressing need to select their business exit strategy. One option to consider is an employee stock ownership plan (ESOP), where the business owner sells the company — up to 100 percent of the stock — to their employees.
This option continues to grow in popularity for a variety of reasons, the first reason being that with employee ownership comes the motivation to work harder to build stock value. Employees ultimately tend to have more pride going to work, and, if the company does particularly well, many long-term employees will be rewarded with a nice nest egg when the time comes to retire.
If you are wondering if an ESOP is the right plan for you, read on to learn more about this option.
While ESOPs haven’t necessarily exploded in popularity, they are more popular today than they used to be. In the past, the complexity intimidated business owners and many lenders were reluctant to fund ESOPs. As knowledge about ESOPs continues to spread, owners and lenders are more apt to choose this route.
Does An ESOP Make Financial Sense?
ESOPs are costly to establish because you need to hire an attorney, a trustee and a valuator. Therefore, they aren’t a good idea for companies without very much profit. A good rule of thumb is that you need at least $500,000 in ongoing profit for it to make economic sense.
Additionally, because an ESOP is a leverage transaction and requires a bank loan, it’s important to have a leadership team that is able to manage the business and pay back the loan over time.
A stable workforce with little turnover is also important. The ESOP pays employees, usually over a period of five years, when they quit or retire; and it’s usually a large portion of their retirement plan.
What Are The Risks?
Like any owner, employees face the same advantages and disadvantages of owning a business — there’s higher risk and reward.
Some ESOPs replace other retirement plans for employees and if all of their retirement is in your company stock, they can be severely hurt if the company doesn’t do well or goes bankrupt. Don’t encourage this. You’ll want to allow for diversification in the employees’ retirement planning strategy.
The Department of Labor and IRS regulate ESOPs, so there will be more oversight from outside parties. Also, with new shareholders, some things like how much money you and the company makes is available to your employees. An ESOP might be your best exit strategy if you:
- Would like your legacy to continue.
- Want your employees to serve as owners.
- Don’t mind the additional oversight and cost.
Also, remember that you aren’t locked into an ESOP forever. If the ESOP no longer meets the needs it was set up for, you can terminate the plan. But just like establishing an ESOP, reversing your decision does not come cheap.
If an ESOP sounds like an exit strategy you would like to learn more about, the very first step is to call in a professional valuations team. You’ll want to have somebody come in and do a feasibility study of what it actually would look like for your business. This study will determine what the value would be and what after-tax proceeds a business owner could expect. Once you have a better picture, you will then be able to determine whether to proceed, go another way or defer until your business is healthier.
Email Rea & Associates to learn more.
This Q&A was originally published in the Insights Accounting section of Smart Business on May 1, 2015. Click here to read the original piece.