January 17, 2022 •Alex Mumblat
Despite many benefits, employee stock ownership plans are often overlooked as succession and liquidity strategies. While the process of establishing and managing an ESOP is fairly straightforward, myths abound.
We run into employee ownership misinformation on a daily basis. Let's tackle 10 of the most common points of confusion and sort out the facts.
"ESOPs are only for S corporations."
Fact: Partnerships and C Corps can also be prime candidates.
A partnership can be incorporated as a C or S corporation prior to the close of an ESOP sale. Existing corporations can also change their corporate structure before formalizing an employee ownership transaction.
These decisions carry unique tax benefits (for companies and selling shareholders), as well as accounting implications. Optimal structures are company-specific and should be considered with guidance from ESOP and tax specialists.
"Employee ownership is too complicated."
Fact: ESOPs are complex, but so are third-party and private equity deals.
All transactions demand specialized advisors and deal partners. While there is a cost to maintaining an employee-owned company, the stakeholder benefits can significantly outweigh the downsides.
"Selling shareholders aren’t adequately compensated."
Fact: ESOP transaction multiples are generally similar to what financial or private equity buyers would pay.
Trustees have a fiduciary responsibility to pay fair market value for a company’s stock. The IRS defines fair market value “the price that would be agreed on between a willing buyer and a willing seller, with neither being required to act, and both having reasonable knowledge of the relevant facts.”
"Employees don’t have the money to buy a company."
Fact: Employees do not pay out-of-pocket for shares.
Even in a leveraged ESOP transaction, the sale is typically financed with combination of outside debt (commercial banks, private debt funds, etc.) and seller notes. This debt is taken on by the sponsor, not the employee trust. As the company pays down these obligations, shares are distributed to the trust and allocated to employees.
"A leveraged ESOP puts too much debt on a company."
Fact: A trustee is obligated to strike a deal in the employees’ best interest. Unsustainable debt runs counter to that goal.
An experienced ESOP advisor should analyze a company's present financial situation, future prospects, and its ability to service debt under stress. If third-party financing is sought, underwriters will do the same. Banks that finance ESOPs typically apply the same degree of scrutiny as in other leveraged transactions. Seller debt is usually subordinated to outside lenders and is unlikely to apply undue pressure on the company’s financial health.
The tax advantages of a properly structured employee stock ownership plan also must be considered. Applicable corporate income tax deductions help increase free cash flow and facilitate efficient debt repayment.
"ESOP lenders require personal guarantees."
Fact: Many lenders are willing to negotiate financing without PGs.
Employee ownership transactions are generally attractive to debt providers. ESOP-related tax deductions can enhance corporate cash flow. Companies with solid financials and sufficient collateral, can secure non-recourse financing.
"Sellers have no say in how an ESOP company is run."
Fact: Employee-owned companies are overseen by a board of directors.
Even in instances where a company is 100% employee-owned, founders and former shareholders often hold board positions and continue to play integral roles.
"Employees gain access to confidential information."
Fact: Disclosure of sensitive financial statements to employee owners is not mandatory.
While employee-owned companies may elect to share some data, plan participants are only required to receive annual statements pertaining to their individual accounts. These are similar to documentation provided for other qualified retirement plans.
"ESOPs prohibit family-ownership."
Fact: Employee ownership can be a valuable tool in succession planning.
Multi-generational businesses can use leveraged ESOPs to create tax-advantaged liquidity events for certain family members and next-generation equity transfers for others. Family members employed by plan sponsors can also participate directly in an ESOP, under certain conditions.
"Employee ownership is permanent."
Fact: ESOPs allow for broad flexibility post-formation.
Employee-owned companies can engage in secondary ESOP sales, stock buybacks, plan terminations, and M&A. Plan trustees have a say in these transactions. Fair market value for plan participants remains a critical concept. But ultimately, a trustee seeks to act in the company’s best interest – even if that entails a sale to a third-party.
For answers to more commonly asked employee ownership questions, check out our video Q&A.