Things to Know for a Successful ESOP
Employee Stock Ownership Plans (ESOPs) can be a great way to increase employee engagement, loyalty and productivity. But putting together a successful ESOP isn’t something you do on the fly—it requires careful planning and thought.
To help make the process easier, we’ve compiled five key facts about newly formed ESOPs below, equipping you with the knowledge to create an effective plan for your team.
What is an ESOP? And how does it work?
First, what is an ESOP?
An Employee Stock Ownership Plan is a type of retirement plan that allows employees to own part or all of the company they work for.
The company sets up an ESOP trust and typically either loans cash to the ESOP to buy shares of stock from the existing owners or contributes shares. Employees then get shares —typically allocated according to relative pay or some other formula. Also, there is usually a vesting period (two to six years), and the longer employees work for the company, the more vested they are in the shares allocated to their accounts.
When employees leave the company, the company buys their vested account shares at the most recent fair value, but the timing of the buyback varies according to the reason for leaving the company.
Not only do ESOPs give employees an additional retirement plan, funded totally by the company, but they provide employees with a sense of ownership along with improved employee satisfaction and productivity, which then can result in higher profits for the company. In fact, according to a study from Rutgers University, “ESOPs increase sales and employment by approximately 2.3 percent to 2.4 percent per year over what would be expected absent an ESOP.”
For the employer, an ESOP provides an alternate exit strategy for owners besides passing the business down to a family member or selling to a third party. It also provides tax benefits, which we’ll cover in more detail below.
Five things to know about newly-formed ESOPs
If you recently created an ESOP for your team or are thinking of doing so in the future, here are five things you should know.
1. The ESOP may be leveraged or non-leveraged
There are several ways to design the ESOP:
- The company contributes its new shares or its purchased shares from treasury to the ESOP,
- The company loans money to the ESOP (in exchange for an internal loan between the company and ESOP) to buy existing shares, or
- The ESOP takes out a loan from a bank to buy shares (which the company then typically assumes in exchange for an internal loan between the company and ESOP).
The first option is referred to as a non-leveraged ESOP because there isn’t a loan. The second and third options are leveraged ESOPs.
In a leveraged ESOP, the internal loan between the company and the ESOP is typically amortized over 10 to 50 years. The company contributes cash to the ESOP (as a contribution, similar to a 401(k) plan contribution) and the ESOP repays the internal loan by sending the same amount received back to the company. As the payment is made by the ESOP, the ESOP shares are allocated to the participants, typically based on a ratio of the payment made over the total remaining payments to be made multiplied times the remaining total shares to be allocated.
2. The company may be operating with a higher debt load
Whether the transfer of ownership to the ESOP is financed by the seller alone or a combination of bank- and seller-provided financing, the company may be operating with a significant amount of debt once the transaction occurs.
Often, this higher debt requires management to perform within financial covenants set by the lender. Covenants vary by lender and industry but may include maintaining a minimum debt service coverage ratio, working capital ratio, current ratio or debt-to-equity ratio.
In these circumstances, it’s helpful for the company to have a Chief Financial Officer (CFO) with the experience and knowledge to manage the company’s financial affairs with those covenants in mind. Before entering into the ESOP transaction, they can develop a three- to five-year business plan and financial projections to help ensure the company can meet its loan covenants and have enough cash flow to grow the business.
3. ESOPs can provide significant tax benefits
For C-corporations, selling shareholders can defer capital gains when they sell their shares to the ESOP by utilizing a 1042 rollover. This benefit was recently extended somewhat to S-corporations, beginning in years after Dec. 31, 2027, to allow a deferral of capital gains up to 10 percent (SECURE Act 2.0).
To qualify for the deferral:
- 30 percent or more of the company must be sold to the ESOP.
- The shareholder must have held the shares for three or more years.
- The transaction proceeds must be invested in Qualified Replacement Property—usually stocks or bonds or U.S. operating companies—within 12 months of the transaction.
This tax benefit isn’t available to S-corporations prior to 2028. However, because an ESOP is a federally tax-exempt entity, the pro-rata earnings of the S-corporation allocable to an ESOP (as a corporate shareholder) are exempt from federal income taxes. In other words, profits that would have been used to pay income taxes can be reinvested into the business, used to pay down debts or put toward acquisitions or working capital needs.
4. You’ll need to navigate a new layer of reporting and regulatory requirements
ESOPs must comply with several reporting and regulatory requirements established by the Department of Labor (DOL) and the Internal Revenue Code (IRC). In addition, the ESOP-owned company will need an annual valuation performed to determine the fair value of the stock each year (which typically involves projections prepared by management).
These requirements can impact multiple areas of the organization, from human resources and employee benefits to executive compensation, tax reporting and financial reporting.
Before forming your ESOP, consult an experienced attorney and/or accountant to ensure you understand these obligations and are prepared to navigate the reporting and regulatory requirements. After forming the ESOP, your advisors can help you stay abreast of ESOP-related financial reporting and regulatory requirements to ensure the plan remains compliant.
5. Prepare for repurchase obligations
When an employee participating in the ESOP leaves the company—whether via retirement, termination, death or disability—the company must buy back those shares. This requirement to buy back shares is known as the repurchase obligation or repurchase liability.
In the ESOP’s first five to seven years, the repurchase obligation generally doesn’t represent a significant liability. However, as time goes on, the company grows, debt is paid down and as a result, the value of the company’s shares increases, the employees become more invested in their shares. As a result, the repurchase liability grows and can significantly impact the company’s cash resources.
Working with an experienced advisor who is well-versed in repurchase obligation issues can help you prepare for those obligations. This preparation ideally starts well in advance of forming the ESOP, when designing the plan and structuring the internal loan.
What company is a good candidate for an ESOP?
Along with a good cultural fit as an ESOP-owned company (recognizing and cultivating the employees as “owners”), a company who is a good candidate for an ESOP is one that has an appropriate level of cash flows (EBITDA = earnings before interest, taxes, depreciation, and amortization) and sound financial reporting. The appropriate EBITDA level is assessed by the ESOP professionals who craft the transaction, which in a leveraged ESOP includes the initial selling price and considers the future payoff of debt acquired in selling the stock to the ESOP and the eventual repurchase obligation to participants. In order to know a company’s EBITDA before a transaction and after becoming ESOP-owned, it is critical to have financial statements prepared in accordance with generally accepted financial statements to ensure a consistent, appropriate presentation of the company’s assets, liabilities and revenues and expenses.
Need help with understanding your financial statements before or after becoming an ESOP-owned company?
Becoming ESOP-owned or being ESOP-owned is complex, but it can benefit employers and employees if done correctly. It is essential to understand the advantages, requirements and obligations, which is much easier to do with the right team behind you. Windham Brannon’s team of professionals is ready to assist you with your ESOP needs. For more information, reach out to an advisor or contact Donna Caruso.
