10 ESOP Myths & Facts

Like any M&A strategy, employee stock ownership plans have unique characteristics and complexities. The latter, combined with limited awareness of ESOPs, frequently drives misconceptions about these powerful business transition tools. 

Confusion can stifle consideration. Many privately held companies that could meaningfully benefit from an ESOP sale often dismiss the strategy out of hand or never entertain it at all. So, let's address the 10 most common myths about employee ownership and clarify the facts.

1) An ESOP's Value

Myth:  Employee ownership isn't worth the time and effort.

Fact:  ESOPs are nuanced, but compared to other business transition options, these plans are highly customizable and offer unique benefits.

Employee stock ownership plans are ERISA-authorized, Department of Labor-regulated retirement plans. There are clear rules that govern the formation and management of these plans. Ongoing plan maintenance also incurs costs, and companies that maximize the benefits of their ESOPs tend to have strong management teams. 

However, for the right company in the right situation, the advantages of a plan can significantly outweigh its downsides. Fair market value for equity, tax advantages for all stakeholders, and continued autonomy are just some of the key differentiators of an employee ownership strategy.

ESOPs are also flexible in their design. Staged sales are a common practice, and transactions can be structured to enable buyouts of individual shareholders in multi-partner businesses. Although employee stock allocations are based on a fixed formula, companies may opt to offer additional, targeted incentives for key team members, including warrants and stock appreciation rights.

2) Corporate Structure

Myth:  Only S corporations can form ESOPs.

Fact:  Partnerships and C corporations can also transition to employee ownership.

At the close of an ESOP transaction, a sponsor company must make either a C or S corporation election. That doesn't preclude LLCs and similar for-profit partnerships from pursuing an employee stock ownership plan. They simply need to convert to a corporation before launching their plan.

Existing C or S corps may also seek to reclassify their tax status upon forming an ESOP. 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 employee ownership and tax specialists.

3) Paying for ESOP Stock

Myth:  Employees can't afford to purchase a company.

Fact:  ESOP participants do not pay out-of-pocket for shares.

In an ESOP sale, a trust purchases company stock on employees' behalf. Plan participants never pay the company for shares, nor do they contribute cash to its employee stock ownership trust. Share allocations are effectively a free benefit for all plan participants.

Financing makes this possible. A company extends a loan to its employee trust to purchase stock. Over time, the sponsor company pays down that "internal loan" on the trust's behalf via pre-tax, non-cash contributions. As this debt obligation is fulfilled, shares are distributed to the trust and allocated to employees.

A second set of financing is arranged by a sponsor company to pay selling shareholders. This "external loan" is generally third-party debt (bank loans, private credit, etc.), seller notes, or a combination of the two. Many commercial lenders are willing to offer financing without personal guarantees. Companies with solid financials and sufficient collateral can generally secure non-recourse financing.

4) Sustainable Leverage

Myth:  A leveraged ESOP puts too much debt on a company.

Fact:  Trustees are obligated to craft sustainable transactions in the best interest of plan participants.

Before finalizing a transaction, experienced ESOP advisors and plan trustees will analyze a company's present financial situation, future prospects, and its ability to service debt under stress. The tax advantages of a properly structured employee stock ownership plan should also be taken into consideration. Applicable corporate income tax deductions can help enhance an employee-owned company's performance and facilitate efficient debt repayment.

If third-party financing is sought, underwriters will do the same. Banks that finance plans typically apply the same degree of scrutiny as in other leveraged transactions. Meanwhile, seller notes are usually subordinated to senior debt, may feature flexible terms, and are unlikely to apply undue pressure on the company’s financial health.

5) Transaction Size

Myth:  ESOPs require 100% employee ownership.

Fact:  Partial ESOP sales are permitted and commonplace.

Although 100% employee-owned companies are afforded notable tax benefits, all-at-once sales are neither mandatory nor universally practical. Many companies initially sell a minority stake to an employee stock ownership trust. Even an initial 30% ESOP sale enables selling shareholders to take advantage of a capital gains tax deferral, also known as a 1042 rollover.

Partial ESOP sales can help owners unlock a portion of their net worth without compromising the independence of their companies. These strategies can also be used to acquire the interests of retiring partners and family members in businesses with multiple owners. Secondary sales are common and at the employee-owned company's discretion.

Another advantage relates to third-party transaction financing which facilitates up-front payment to selling shareholders. An ESOP loan is typically based on the sponsor company's cash flow and/or asset value, rather than its transaction value. Whether 30% or 100% of that company is sold to an employee trust, the amount of financing it can secure will likely remain constant. So, an owner who sells a minority stake to an ESOP will likely get a greater portion of their sale proceeds at close.

6) Sale Price

Myth:  Selling shareholders aren't adequately compensated in an ESOP sale.

Fact:  An employee stock ownership trust can pay fair market value (FMV).

ESOP trustees have a fiduciary responsibility to pay no more than fair market value for a company's stock. The IRS defines FMV as "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." This is effectively the same price a financial buyer (such as private equity) would be willing to pay.

It's true that a strategic buyer could pay more for a private company than an ESOP, but a strategic sale isn't necessarily a sure thing. The transaction process can be arduous, close rates are relatively low, and sale proceeds are subject to capital gains taxes. An acquisition target will also likely lose its autonomy.

7) Corporate Decision-Making

Myth:  ESOP-owned businesses are run by employees and plan trustees.

Fact:  An employee-owned company is led by its board of directors.

Managerial and operational leadership of an ESOP-owned company rests with its corporate board. If a business is not board-led prior to a plan's formation, a board is installed before an ESOP transaction is completed. Even in instances where a company is 100% employee-owned, business owners and former shareholders often hold board positions and continue to play integral roles.

Trustees maintain oversight and vote ESOP-owned shares of a company. They are only required to seek voting instructions from plan participants when a board entertains fundamental corporate changes, including substantial sales of company assets, mergers, recapitalizations, reclassifications, dissolutions, or consolidations.

8) Sharing Company Information

Myth:  Employee owners gain access to confidential information.

Fact:  Disclosure of sensitive financial statements to ESOP participants is not mandatory.

Employee owners must be provided access to plan documents and receive annual statements detailing their individual account information. The latter is similar to the documentation provided for other qualified retirement plans. In general, a trustee will only share privileged information in coordination with the sponsor’s board and management.

ESOP-owned companies may elect to share some data with plan participants. Commonly known as "open book management (OBM)," this practice carries its own set of pros and cons. Trustees are not required to enforce OBM - that decision rests with a business's board of directors.

9) Family-Owned Businesses

Myth:  Employee stock ownership plans require family members to fully divest from a business.

Fact:  Family and ESOP-ownership of business can go hand-in-hand.

Owners of 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 or hold equity outside of a plan.

Even when a business is 100% employee-owned, synthetic equity can be created as part of an ESOP transaction and either gifted or sold to family members. Grantor Retained Annuity Trusts (GRATs) and Intentionally Defective Grantor Trusts (IDGTs) can also be used to facilitate these tax-efficient transfers.

All of these strategies can help family-owned businesses maintain their legacies and their unique character. As time passes, family members buy back or retire ESOP shares to increase their position in the company.

10) Future Transactions

Myth:  ESOPs cannot be altered or terminated, and sponsor companies can't be sold to third parties.

Fact: Employee-owned businesses have broad flexibility to make M&A transactions.

Employee-owned companies can engage in secondary ESOP sales, stock buybacks, and plan terminations. These firms can also make strategic acquisitions and accept offers to be purchased by competitors or financial buyers.

Plan trustees have a say in these transactions, and plan participants must receive fair market value for their stock. Ultimately, a trustee seeks to act in the best interest of the company and its shareholders, even if that entails selling the company to a third party.

For more ESOP facts and answers to more commonly asked employee ownership questions, check out our video Q&A.