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ESOPs Fable: an overview of what an ESOP is and what should be considered

The Fable

A sheepdog getting to the end of her prime working years, was told by the farmer that her final task was to select an appropriate replacement. So, early the next morning, she began her search of the farm for a suitable heir to her position.

The first noise that caught her attention was the sound of the rooster crowing. ‘Ah yes, the rooster is a great replacement as they wake early before the sheep and will help get them out of bed.’ However, before long she realized that the rooster was constantly crowing, with no purpose, and thought the flock needed direction and guidance, not just an alarm clock.

Undeterred she headed to the barn and found the donkey. The donkey is the most useful animal on the farm, constantly helping the farmer with their tasks. She suggested the donkey lead the sheep, but he was stubborn and kept changing the terms on which he would work. Frustrated with the donkey’s inability to compromise, the sheepdog decided he was no leader and eventually gave up and moved on.

The heat of the afternoon sun grew, and she headed for the water trough, when she thought ‘The pigs! They are smart and can certainly guide the sheep.’ But the pigs were nowhere to be found, instead they had left the pen for a mud pit in the barn to escape the sun. The sheep are outside whether it is hot or cold and the pigs could not be relied on to care for the sheep.

Defeated the sheepdog approached the farmer at the end of the day, who was to her surprise smiling. “You did it!”. The sheepdog looked confused, and then realized the flock was coming in from the field. Unbeknownst to her, they had let themselves out to the field and came back as the sun was setting on their own, as after years of working together they had memorized the routine.

The morale of this ‘ESOP’ fable is that sometimes the best succession plan for a business is to hand the firm over to the existing employees.

What is an ESOP?

Per the IRS, an ESOP (or employee stock ownership plan) is an IRC section 401(a) qualified defined contribution plan that is a stock bonus plan or a stock bonus/money purchase plan. In plain English, an ESOP is way for companies to transfer ownership to their employees. This can be done by allowing employees to buy stock directly, have it given as a bonus, allow for stock options or through profit-sharing plans.

Why are ESOPs used?

ESOPs are commonly used; To provide an exit strategy for the business owner: Here, privately held companies can create an ESOP to allow employees to pool together to create a market for the shares of the company. Typically, the company will do this in one of two ways; either by making tax-deductible cash contributions into the ESOP or having the ESOP borrow money to buy the shares. To expand their employee benefits: ESOPs are typically used in conjunction with an existing retirement plan and would allow a company to defer employer matching or contribution dollars into the ESOP to buy company stock. Tax Benefits: While this is not the primary use case for creating an ESOP, it is certainly a nice perk! Many of the contributions to the ESOP are eligible for tax-deductible status, as well as loans an ESOP takes out to buy company stock, and other features of the ESOP have preferential tax treatment as well.

Is my company the right fit?

Here are 6 key characteristics of a good ESOP candidate:

  1. Privately held corporations (either C or S corp status)
  2. Stable businesses with established clients and markets
  3. Demonstrated history of profits and cash flows
  4. Experienced management team
  5. At least 30 employees with high tenure and low turnover
  6. Owner(s) looking to sell/exit with clear objectives and time frames

What are the potential downsides or concerns?

ESOPs are just like any other long-term business decision and come with a variety of risks and concerns that need to be considered before moving forward. Here are a few of the most common ‘cons’ to know:

  • All long-term business decisions come with inherit risk. Consider economic uncertainty and the effects a downturn in business productivity may have on a company’s ability to repay its ESOP loan.
  • Cost of maintaining an ESOP. This is not a one-time transaction and comes with annual expenses around the testing, recordkeeping, and trustee services.
  • Speaking of testing… the ESOP is subject to discrimination rules – just like your 401(k) – and does not carry the option to ‘pick and choose’ who is eligible to participate.
  • Time the original owner(s) is involved. Unlike a traditional sale, in which an owner could complete the transaction and walk away, depending on the bank financing they may ask the owner to remain involved for a period of time to ensure business stability.
  • Lack of education and expertise on this subject. This is not a widely known technique and your normal business partners (think CPAs, Banks, or TPAs/Record Keepers) may be undereducated or incapable of facilitating this solution, and therefore hesitant to present this idea.

Bottom Line:

ESOPs are a mutually beneficial resource for business owners and their employees. It provides a unique exit strategy for the employers and creates greater buy-in and financial opportunities for the employees. However, these are complex strategies that will likely require a team of experts to implement properly, and ensure employees understand the full benefit.

 

 

Deschutes Investment Consulting, LLC provides financial guidance for businesses and individuals combining dependable expertise with honest advocacy since 1997.  Our thanks to them for pulling this resource together! 

 




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