Employee Ownership: The Treats, the Tricks and What Owners Need to Know

Few succession strategies generate as much enthusiasm as selling a company to its employees through the use of an Employee Stock Ownership Plan (ESOP), and for good reason. An ESOP can reward the people who helped build a business, preserve its independence, and provide a path to liquidity. But using an ESOP to facilitate the sale of a company requires making a long-term commitment to the strategy, and it carries ongoing financial and fiduciary responsibilities. Owners who understand both the opportunities and the complexities are far better positioned to decide whether providing for employee ownership through an ESOP fits their goals.

The Treats: Why Owners Are Drawn to ESOPs

For many business owners, the appeal begins with alignment. When employees share in the growth of the company’s value, their interests tend to move closer to those of ownership, and companies that connect individual contributions to company performance often see stronger engagement and a sharper focus on long-term results.

Retention is a related benefit. Because ESOP accounts build over time and are subject to vesting, the plan gives key employees a meaningful reason to stay.

An ESOP can also serve as a succession solution. Owners without a family successor or an appealing outside buyer can create a market for their shares, whether in a single transaction or in stages that allow the owner to remain involved during the transition. Depending on the company’s structure, significant tax advantages may apply as well, including potential capital gains deferral for sellers of C corporation stock and relief from federal income tax on ESOP-owned earnings in an S corporation. Each carries technical requirements that must be satisfied carefully.

The Tricks: What Owners Often Underestimate

The same structure that creates opportunity also creates ongoing responsibility. An ESOP transaction requires a commitment to fund the costs for legal counsel, an independent trustee, an independent appraiser, and often lenders and accountants that have specific ESOP expertise. The expense of doing a proper ESOP transaction does not end at closing.  The expenses for having an ESOP trustee, annual stock valuations and the right firm to handle plan administration and compliance with the complicated rules under the tax code and ERISA that apply to ESOPs continue for the life of the plan.

ESOP repurchase obligations are perhaps the most frequently overlooked issue. As participants retire or leave, the company generally must buy back the shares of company stock in ESOP participant accounts when they die, retire or otherwise terminate employment with the company at the fair market value of the stock. That liability grows as the company’s value rises and the workforce ages, and companies that have not built repurchase forecasting into their financial planning can face significant cash-flow pressure when capital is needed most.

Financing deserves similar attention. Many transactions are leveraged, and the company, not the owner, repays the debt, often subject to financial and operational covenants that limit flexibility. Sellers who agree to accept promissory notes from the company instead of cash payments when they sell their stock to an ESOP also take on the credit risk of the business they have just sold.

In addition, ESOP ownership requires changes to the governance of the company. Employees do not run the company, but trustee oversight, board composition, and communication with participants all become part of the picture, and owners accustomed to deciding alone may find the adjustment significant.

The Through-Line: Fit Matters More Than Form

An ESOP is not right for every business. Companies with thin margins, volatile earnings, or a shallow management bench may struggle to handle the debt and repurchase obligations an ESOP creates. Owners should ask whether their goals are primarily financial or include legacy, whether projected cash flow can support both transaction debt and future repurchases, and whether a capable team can lead without the founder.

The owners who benefit most from employee ownership approach it with clear eyes about what the model demands, and invest early in the financial, cultural, and governance capabilities to meet those demands. Whether an ESOP is a sweet deal or one to pass on depends on the answers, and those answers are best developed with experienced advisors involved from the start.

Considering whether an ESOP is the right move for your company? Reach out to David Solomon or another member of LP’s ESOP Services Group.