An Employee Benefit and Shareholder Liquidity Strategy
An employee stock ownership plan (ESOP) enables privately-held companies to sell equity, at an independent valuation, to an employee trust. These are not stock options plans. Instead, an ESOP is an ERISA-authorized retirement plan that invests directly in employer securities.
Read ahead for details on how ESOPs work, key benefits, and employee ownership pros and cons.
And for a quick study on the basics of leveraged ESOPs, download our concise guide.
Two Common Types of Employee Stock Ownership Plans
Contributory ESOP
A closely-held company establishes a plan and periodically issues new stock to an employee trust. Cash can also be contributed to the trust so that it may buy company shares. The sponsor receives tax deductions equivalent to the fair market value (FMV) of equity at the time of contribution.
Leveraged ESOP
Equity is sold by the plan sponsor to an employee trust in a financed transaction. Selling shareholders are paid FMV and can defer/potentially eliminate taxes on those gains. The company receives income tax deductions equivalent to the leveraged ESOP sale amount.
How a Leveraged ESOP Works
Who is the Buyer?
An employee stock ownership trust, representing at least 10 ESOP participants, buys company stock.
Who Sets the Price?
The price is negotiated with an institutional trustee, based on an independent valuation.
How is it Funded?
Sponsors borrow money on the trust's behalf, in the form of third-party financing and/or seller notes.
Who Gets Shares?
Full-time eligible employees are allocated company shares, proportional to their annual compensation.
How is Stock Earned?
A portion of all ESOP shares is allocated annually; the shares vest within three to six years.
How do Employees Cash Out?
Vested stock is sold back to the company, at a current valuation, when employees depart.
Who Benefits from Employee Ownership?
BUSINESS OWNERS
Selling shareholders gain liquidity and asset diversification
Can defer capital gains taxes on sale proceeds
Maintain upside potential and an important role in the company
COMPANIES
Receive tax benefits that enhance corporate cash flow
Employee-owned S corporations can become income tax-free entities
Create a novel employee benefit plan to retain and attract talent
EMPLOYEES
Full-time employees earn ownership interest and gain a unique retirement benefit
Can reap the benefits of company performance
Employee owners secure workplace stability and peace of mind
ESOP Pros & Cons
These strategies carry significant benefits, but it's important to understand the full range of tax benefits and corporate implications. If you own or advise a private company, and you're considering a transaction, it's also wise to compare employee ownership plans against other M&A options.
Employee Ownership Questions? We can Help.
When CSG Partners was founded in 2000, we made education a priority. That remains central to everything we do. So, if you have questions about selling to an employee stock ownership plan, or how to prepare for a transaction, or operating as an employee-owned company, you've come to the right place. You'll find answers below and even more on our ESOP Resources page.