Owners of closely held businesses who are considering transition of ownership may consider Employee Stock Ownership Plans (ESOPs) as an alternative to more traditional transition opportunities. ESOPs are attractive to many business owners, and have significant benefits for owners, the businesses and employees. However, ESOPs also have drawbacks.
A better understanding of the advantages and disadvantages of ESOPs can help any business owner determine if a partial or total sale to an ESOP is a solution that makes sense. And that owner needs professional advisors who have been through the process many times.
WHAT IS AN ESOP?
An ESOP is a qualified employee benefit plan that is structured to primarily invest in employer stock. The first step to establish an ESOP is to set up a trust to purchase stock from the owner(s). After the ESOP trust is established, the ESOP borrows money from an outside lender to buy all, or a portion, of a business. The ESOP repays its loan through periodic pre-tax contributions made by the company. As the loan is paid down, shares are released from collateral, and allocated to eligible employees based on their level of compensation. The longer an employee works for the company, the more shares that are allocated to his/her account, and the more the employee becomes vested in his/her account, and thus in the company.
ESOPs create a ready market for business owners looking to transition ownership, and offer many ongoing advantages, such as:
- Owners have more control over the transaction when selling to an ESOP, as compared to an external sale–there are no competitors doing diligence on the business, and far less disruption.
- Selling a company to an ESOP provides for continuity in the company’s workforce and operations. This may be particularly important for an owner who has worked hard alongside his/her employees to build the company over many years.