Despite appealing reasons for business owners to establish an employee stock option plan, or ESOP, an enormous knowledge gap exists that prevents many owners from even considering one. Many view an ESOP as the last resort when contemplating an eventual retirement or succession plan, believing it too complicated.
If that’s your view, let me address the misperceptions. Having structured over 300 business family and private business transitions, I’ve found that an ESOP should absolutely be one of the alternatives weighed by business owners for two powerful reasons: ESOPs offer potentially compelling benefits at the time of sale. And, because they increase employee engagement, ESOPs can help improve a company’s performance.
ESOPs increase optionality for business owners
Increased optionality is the chief reason business owners should think about establishing an ESOP. At the time of sale, an ESOP gives an owner more than one solution to a complex situation. It also provides personal liquidity, wealth diversification and tax advantages. Quite simply, an ESOP is a leveraged recapitalization that uses a business’ equity value to obtain debt financing. Further, the ESOP’s shareholder is exempt from federal income taxes. Let me note that again: Sale of an ESOP-owned company can be structured in such a way that the company, and not the shareholder(s), pay federal income taxes.
In view of these considerable benefits, what often gets in the way? Three persistent misconceptions diminish owners’ interest:
- The belief that owners lose operating control of their companies when they create an ESOP. Not true. The ESOP is a beneficial owner as well as a retirement plan trust, but ESOP members don’t sit on the board and don’t manage operations. As a trust, they certainly will observe management decisions and strategies to grow the value of their share, but they are not involved in day-to-day business oversight. Compare that to the hands-on involvement that sellers to private equity firms experience.
- The fallacy that an owner won’t get a fair market value by selling to an ESOP. While it is true that an ESOP cannot pay more than a business’ fair market value, the ESOP can pay every dollar of fair market value, determined through a market valuation exercise (versus an auction). Whatever the reason, private equity firms and investment advisors involved in the possible purchase of a business often don’t do much to dispel this misleading notion that owners won’t obtain fair market value through an ESOP sale.