The Pros and Cons of ESOPs

Employee stock ownership plans (ESOPs) are unique M&A alternatives that can deliver meaningful economic benefits to all stakeholders while maintaining the independence of the companies that form these plans. Thousands of companies nationwide have completed employee ownership transitions to address a variety of strategic goals and use cases. However, like any transaction, an ESOP sale comes with advantages and potential downsides. It’s essential to consider these pros and cons if you’re considering an employee stock ownership plan for your closely held company.

Sale Value

✅ Pro:  Sellers are Paid Fair Market Value (FMV)

The Internal Revenue Service defines FMV as the price a knowledgeable, willing buyer would freely pay for a willing seller on the open market. An ESOP trustee has a fiduciary responsibility to uphold this standard.

FMV is derived through an independent valuation, followed by negotiations between a plan’s sponsor and trustee. An ESOP sale is only consummated if both sides agree on a price. When a company establishes an employee stock ownership plan, selling shareholders can expect fair compensation for their equity.

❌ Con:  ESOPs Cannot Offer More than FMV

Sometimes, corporate acquisitions offer buyers unique synergistic benefits. Certain companies are ideally suited to meet acquirers’ vertical integration, horizontal expansion, or market share goals. If a strategic buyer believes a transaction will drive economies of scale, that company may pay a premium that exceeds the FMV price offered by an employee stock ownership trust.

An ESOP’s capital gains tax advantages can help close or eliminate this gap, in terms of after-tax sale proceeds. Nonetheless, there are occasions when a strategic sale will be the most financially advantageous option. 

Efficiencies & Complexities

✅ Pro:  An Employee Trust is a Known Buyer

M&A due diligence can leave a seller exposed. Even if a sale isn’t consummated, sensitive corporate information and trade secrets can be revealed to competitors. Although an ESOP trustee will undertake a rigorous fact-finding process prior to sale negotiations, they are required to maintain confidentiality. 

A professional ESOP trustee is obligated to seek fair market value, but not at the expense of the company's reputation or future prospects. Remember, an employee stock ownership trust is a known buyer with a common cause—to help its sponsor company perpetuate and prosper.

❌ Con:  An ESOP Transaction Process is Highly Structured

ESOPs are regulated by the US Department of Labor, with formal rules and restrictions codified by the Internal Revenue Service. As a result, employee ownership transactions feature complexities that aren’t often encountered in typical M&A deals.

In addition to working with designated specialists (an institutional trustee, trustee’s counsel, and an independent valuation firm), the transaction process includes unique steps, such as determining which employees participate and authoring a plan document. There’s also the added need to educate staff about how employee ownership works. Despite these nuances, the cost to complete a leveraged ESOP sale is typically lower than the costs associated with third-party sales or private equity transactions.

Transaction Financing

✅ Pro:  Non-Recourse ESOP Financing is Available

Many commercial lenders are attracted to ESOPs. The associated tax incentives drive increased cash flow, while companies with strong employee ownership cultures statistically outperform their peers.

Senior debt, offered without personal guarantees and at reasonable terms, can often finance a sizable portion of a leveraged ESOP transaction. Higher-interest-rate mezzanine debt is also available in situations where additional upfront cash is needed. Employee-owned companies repay these loans with pre-tax corporate cash.

❌ Con:  Selling Shareholders Often Provide Partial Financing

Although ESOP lending options are plentiful, most transactions include a seller note component. The extent of seller financing often depends on a company’s fundamentals and industry. For some businesses, this detail is irrelevant. Debt-averse firms can opt to structure transactions that are exclusively seller-financed.

Selling shareholders with the sole goal of maximizing their cash at closing may be better served in a private equity sale. Nonetheless, their capital gains will be taxable, and sellers may be required to roll equity into the deal.

ESOP Benefits & Costs

✅ Pro:  Tax Benefits for all Stakeholders

Since the passage of the Employee Retirement Income Security Act of 1974 (ERISA), Congress has formally encouraged the establishment of employee-owned companies. With the goals of promoting working-class wealth creation and stabilizing the middle market, substantial ESOP tax incentives were included in the landmark legislation. Lawmakers from across the political spectrum have since expanded those benefits for all stakeholders.

• Sellers can blunt or eliminate capital gains tax burdens with a 1042 rollover
• Companies earn income tax deductions equivalent to their ESOP sale price
• 100% employee-owned S corporations pay no income taxes in most jurisdictions
• Employees can roll their ESOP stock sale proceeds into another qualified retirement account

❌ Con:  ESOPs Require Ongoing Maintenance

Because an ESOP is a qualified retirement plan, albeit one that invests primarily in employer securities, these plans also fall under the jurisdiction of ERISA. The DOL requires plan sponsors to run annual, independent valuations and submit a Form 5500.

Like other defined contribution plans, including 401(k)s, a third-party administrator (TPA) handles day-to-day oversight of the plan. TPAs also manage annual statements, vesting schedules, and share repurchases. The associated costs are in line with other contribution plans.

Long-term Outlook & Upside

✅ Pro:  Independence, Upside, and Flexibility

Unlike an outright third-party sale, an ESOP transaction can help ensure continuity of leadership while maintaining the legacy of a business. Sales of minority interests are common, and shareholders are still entitled to capital gains tax deferrals, provided that at least 30% of the company is sold to an employee trust.

Even in the event of a majority or 100% ESOP sale, a company’s board of directors will continue to operate the business. In all scenarios, selling shareholders can maintain meaningful roles with their companies. That keeps founders and key family business members engaged.

When ESOPs prosper, that upside is available to all stakeholders. Vested employee owners and shareholders with retained interest can tangibly benefit from a company’s growth. Selling shareholders may also receive synthetic equity (or warrants) as part of an ESOP transaction. As a result, they, too, can maintain upside potential.

Finally, it’s important to note that an ESOP isn’t necessarily an end-all, be-all transaction. Secondary sales and share buybacks are common next steps. An employee-owned company can also opt to engage in M&A. If an employee-owned company is sold, plan participants receive their share of the proceeds. That can turn a commonly negative event for employees into a positive, life-changing experience.