A Business Owner’s Case for Employee Stock Ownership Programs (ESOPs)
In honor of Employee Ownership Month, I thought it would be appropriate to celebrate this mechanism for granting employees equity in the company in a manner that benefits all parties. I will confess that when I first heard about ESOPs, I was skeptical. It sounded too good to be true, which always makes me leery. Because of this, I reverted to my typical methods of discovery, reading up on the program, joining ESOP associations, and talking with owner/members. The following is a recap of what I have learned and where I stand on the topic today.
For starters, ESOPs are not a silver bullet for company ownership.
Setup costs run in the six figures, and you will need a trustee and annual certified valuations. There is also the repurchase obligation, which we will dig into more deeply a little bit later. For these reasons, it is frequently recommended that a company not pursue a transition to ESOP until they are larger than twenty-five employees, and $5M in revenue. The business should have a good distribution of age ranges within their workforce.
So, what makes ESOPs so great when they are appropriate?
➊ The ESOP program is a federally recognized retirement program. As such, the allocation of equity to employees does not create a taxable event as it would if they were to exercise a stock option. In fact, the employee can roll over the cash from selling this equity into another federally recognized retirement program and not have a taxable event until they use the money.
➋ On the side of the organization, the portion of the company owned by the ESOP does not pay federal taxes.
➌ ESOPs also provide guaranteed liquidity for employees as they retire or exit the firm. Section 409(h) of the Internal Revenue Code states that employee members of an ESOP have the right to require the employer to repurchase their stock at a fair market value, also known as a put right. When employees receive stock options, their liquidity is tied to the liquidity of the organization, meaning that they often need to wait for the company to sell or go public before they can recognize any earnings from the stocks.
➍ The ESOP structure, when managed properly can be a powerful employee retention mechanism. This is likely why the top four largest ESOPs in the US are supermarkets, an industry known for high turnover. ESOPs are a great organizational structure for creating a genuine sense of personal ownership and engagement with a company’s overarching vision. The ESOP structure has created more blue collar millionaires in the US than any other mechanism in our history, and for that alone, it is something to be appreciated.
With all of this said, as I alluded to earlier, ESOPs are not all rainbows and unicorns.
There is the matter of repurchase obligations, which the company will need to divert cash flows to cover. There are several mechanisms for dealing with repurchase obligation coverage, but if your company has heavy staff concentration in a specific age group, there could be a double impact of replacing a significant portion of the workforce when they all retire coupled with the significant cost of repurchasing their accrued equity. If not properly planned for, this can be an exceptionally detrimental event for the operation. The ESOP structure is also the most aggressively regulated structure by the Department of Justice, so if you have or are considering creating an ESOP, be sure to keep tidy records because odds are strong that you will be audited at some point.
On balance, I have tremendous respect for any business owner who believes that their people are the core of their business enough to literally give the business to them. That is why Blue Sky Business Resources has committed to becoming an ESOP when we grow to a size that this move is feasible. I am proud of our government that created this structure to benefit small to medium sized businesses and their teams, and I salute all of the men and women who work to protect, support, and engage in this form of business operation.
To all the entrepreneur owners out there, and to all the individuals and organizations that fight to maintain this as an operational possibility, I would like to wish you a Happy Employee Ownership Month!