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ESOP Pros & Cons
Employee stock ownership plans (ESOPs) are unique M&A alternatives with distinct advantages and potential downsides. Learn how these strategies compare to other business succession, exit, and liquidity options.
Get our "ESOP Pros, Cons, and Comparisons" guide.
EMPLOYEE OWNERSHIP BASICS
Are there different types of employee stock ownership plans?
Yes. The two most common types are contributory and leveraged ESOPs. Contributory plan sponsors periodically issue new shares to an employee trust. Cash can also be contributed to a trust so that it may purchase company stock. In a leveraged plan, an employee trust borrows money to purchase an equity stake from a company sponsor.
Are partial sales permitted?
Yes. Also known as minority ESOP transactions, these strategies enable targeted shareholder exits and partial liquidity events. Sponsor companies maintain the freedom to explore various transaction options, while individual shareholders can retain non-ESOP equity. Additional shares can be sold to a company's employee stock ownership trust at a later date.
What laws govern ESOPs?
The Employee Retirement Income Security Act of 1974 (ERISA) codified the modern ESOP, set plan standards, and gave the Department of Labor oversight jurisdiction. Subsequent, bipartisan legislation has both clarified regulations and expanded the set of tax incentives available to ESOP stakeholders.
TAX ADVANTAGES
What is a 1042 Rollover?
An ESOP-exclusive benefit, this tax-deferral strategy enables selling shareholders to defer and potentially eliminate capital gains burdens on their sale proceeds. To earn the benefit, a seller must reinvest their proceeds in Qualified Replacement Property within 12 months of their ESOP transaction date.
Can employee-owned companies earn tax incentives?
Yes. When shares are transferred to an employee stock ownership trust, sponsor companies may earn state and federal income tax deductions equal to the fair market value of that stock. In addition, 100% ESOP-owned S corporations can become income tax-free in perpetuity.
Are employee owners entitled to tax benefits?
ESOP participants can roll plan benefits into other tax-deferred retirement accounts, including 401(k)s and IRAs. Rollovers must be completed within 60 days of a plan distribution. Otherwise, distributions and dividends are subject to standard taxes and early withdrawal penalties.
FORMING A LEVERAGED ESOP
Typically, what is the first step in a plan formation?
Interested companies often commission a financial analysis and feasibility study, led by an experienced advisor. This work can help stakeholders quantify plan benefits and costs, review structuring options, ascertain fair market valuation, and appreciate the overall viability of a potential ESOP.
How is a trustee selected?
Ideally, a selection committee, designated by the sponsor company’s board and comprised of key employees, will select the trustee. An interview process featuring several qualified candidates is typical. To determine best fit, the committee will consider multiple factors, including candidates’ independence, experience, and competence.
How is an ESOP sale price determined?
A sponsor company and its ESOP trustee negotiate final transaction pricing. An employee stock ownership trust cannot pay more than fair market value, an IRS standard that is typically a composite of discounted cash flow modeling, public market comparisons, and precedent transaction analysis.
MANAGING ESOP-OWNED COMPANIES
What is an ESOP trustee’s role?
A trustee is the employee stock ownership trust’s shareholder of record. They have a fiduciary obligation to all plan participants. During an ESOP formation, a trustee represents and negotiates on employees’ behalf. Post-transaction, they ensure the ESOP’s terms are followed and executed by the plan’s sponsor.
Who runs an ESOP-owned business?
The company’s board of directors oversees management and operations. The ESOP trustee typically does not serve on the board. Instead, the trustee maintains an oversight role and votes the employee-owned shares in the event of a major transaction, such as a sale, merger, acquisition, or recapitalization.
Can a plan be modified or terminated?
Yes. With a trustee’s consent, plan terms can be modified. In addition, ESOP financing can be restructured, and follow-up transactions—including secondary sales, stock repurchases, and plan terminations—are common. Under certain circumstances, a sponsor company’s board of directors can replace a plan’s trustee.
