Exploring the ESOP Opportunity

Is it a winning strategy for your business?

An employee stock ownership plan (ESOP) enables owners of privately held businesses and other shareholders to liquidate their company stock while enjoying tax benefits and keeping their jobs until they're ready to retire.

A type of retirement plan that invests primarily in company stock, an ESOP holds its assets in a trust in accounts earmarked for employees. Plan participants don't directly own the stock but typically redeem shares when they leave the company.

The ESOP purchases shares from owners at fair market value, generally by borrowing from a financial institution, and makes principal and interest payments with corporate funds contributed to the ESOP. The entire cost of the loan may be tax deductible.

According to the most recent government data posted at the National Center for Employee Ownership (NCEO) website, there are an estimated 6,700 ESOPs in the United States, covering 14 million participants and holding total assets of more than $1.3 trillion.Footnote a

Feasibility analysis

Because an ESOP isn’t for every business, it makes sense to conduct an ESOP feasibility analysis. Many of the criteria you should consider are the same performance metrics a lender or purchaser would examine when deciding whether to lend to or purchase a company. That's because creating and running an ESOP essentially is a slow-motion sale of the company whose buyer—the ESOP trust—needs assurance it's purchasing a viable company at a fair price.

The financial performance indicators used in your analysis should include revenue, historic and anticipated profitability, and balance sheet strength.

Because ESOPs are qualified benefit plans under the Employee Retirement Income Security Act of 1974 (ERISA), their viability must also be assessed in light of other existing qualified plans and the company's retirement benefit strategy.

Employee demographics also play a big role in any feasibility study. The smaller the number of employees relative to the value of the company, the more challenging it is to make an ESOP work.

Launching an ESOP

Some important steps in launching an ESOP include:

  • Securing an independent valuation of the business to affirm the assumptions made during the feasibility analysis
  • Lining up a credit facility that will enable the ESOP trust to purchase company shares
  • Selecting an ESOP trustee (an institution or an individual) and establishing an ESOP committee, whose function is plan oversight and communication between the trustee and plan participants
  • Planning and executing the integration of the ESOP with existing retirement plans, possibly including the suspension of matching or nondiscretionary 401(k) plan contributions
  • Drafting and adopting plan documents
  • Creating and executing a comprehensive employee communication strategy

Once the ESOP is up and running, the task of keeping it in good working order is much the same as with other qualified plans, although the ESOP's repurchase liability must be carefully monitored and managed.

Footnote a US Department of Labor data available at nceo.org/articles/esops-by-the-numbers(opens in a new tab).

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