Navigating Employee Stock Ownership Plans (ESOPs): A Guide for Small Business Owners
- An ESOP is a retirement plan that puts ownership in the hands of workers, offering tax advantages and a succession opportunity for the owner
- While the initial costs are high and plan maintenance is required, established small businesses may find ESOPs to be ideal for promoting long-term growth
- Companies with 30-100 workers may be best suited for an ESOP
Rewarding and motivating employees with a stake in your company can be an effective strategy. An Employee Stock Ownership Plan (ESOP) is a qualified retirement plan that allows employees to become partial owners by earning shares in the company for whom they work.
ESOPs can be complex, but for growing small businesses, they can be a practical tool to both compensate employees and leave room for continued expansion. What’s more, ESOPs can be a means through which a business is transitioned from its original owner to new executives, all while unlocking key tax benefits.
Let’s dig into the nuances of an ESOP to help you determine if such a program might soon fit into your business’s long-term plan.
What Is an ESOP?
According to the IRS, an ESOP is an individually designed stock bonus plan, which is qualified under Internal Revenue Code Section 401(a), or a stock bonus and a money purchase plan both of which are qualified under IRC Section 401(a), and which are designed to invest primarily in qualifying employer securities.[1] In short, it’s a retirement plan that allows workers to become owners, and as with a 401(k) plan, an ESOP must comply with the Employee Retirement Income Security Act (ERISA) along with other strict regulations.
Under the ESOP umbrella, you as the owner put up shares of the company (or cash to purchase shares) into an employee stock ownership trust (ESOT). The trust holds the shares until they are distributed to workers who earn equity based on a variety of factors, usually tenure and salary.
For small business owners, there are a pair of benefits from the get-go:
- Tax Advantages: Contributions to an ESOP are tax-deductible. Moreover, there’s the potential to bypass some federal income tax on earnings if the ESOP is the majority owner of an S-corporation. Also, be sure to take into account the tax benefits to the plan participants – tax-advantaged growth is possible within an ESOP.
- Ownership Diversification: While doling out stock options usually rewards highly compensated employees, an ESOP is commonly available to all workers, fostering a sense of team ownership and shared success.
Building and Transitioning a Small Business Via an ESOP
To go with the immediate wins that can come from implementing an ESOP, there are longer-term advantages you might want to consider. In my work, I find that many small business owners are surprised by their success as the years and decades go by.
Eventually, they are faced with identifying and executing the proper succession and legacy strategy. An ESOP is one of a few options that can efficiently help you exit your practice. During your journey as owner, offering tax-advantaged equity stakes to employees can be an effective method to attract and retain top talent. Let’s flesh out those benefits.
- Succession Planning
Rather than working with consultants to find a private buyer, exiting via an IPO, or handing off a business to a small group of partners, an ESOP often preserves the culture you built. Your ownership claim can be passed on to the workforce you help mold. Additionally, the transition can be done over a number of years, and not all at once. This helps ensure continuity in both operations and within the company culture.
- Preserving Top Talent
But before you think about your exit, an ESOP can assist in growth efforts, too. When employees know they are owners, they are more likely to buy into your vision and feel intrinsically motivated. The result is a sense of pride in what they do each day, leading to a more engaged and productive workforce. Ultimately, that feeling of purpose translates into your bottom line.
Moreover, as a team sees their equity share and value rise, they are less wont to hop to perceived greener pastures. Lower employee turnover reduces costs and builds human capital under your business’s roof.
Is an ESOP Right for Your Small Business?
An ESOP is among the more complex small business retirement plans. Though the benefits can be substantial, you must determine if it’s the right fit. Here are the primary factors to weigh.
- Company Size: While there isn’t a requirement on the number of workers, you should have at least a few dozen employees before creating an ESOP. If you have, say, 50 people on payroll, then an ESOP might make sense. An ESOP is not confined to small and medium-sized companies – Publix Super Markets is the largest employee-owned company in the US, and the large grocer rewards its workers with shares.
- Financial Situation: Along with needing more than a handful of employees to make it work, the business should have a history of profitability and a roadmap for growth. Solid cash flow and a healthy balance sheet should likewise be characteristics of your firm before constructing an ESOP. If you operate in a highly cyclical industry, an ESOP could be riskier, however.
- Tax Status: The company should be structured as anS-corporation or C-corporation.
- Costs: Expenses related to creating an ESOP can be high, which is why you want the business to be in solid financial shape before considering the program. The National Center for Employee Ownership notes that the total bill could run upwards of $100,000 to $150,000.[2] There are, of course, ongoing costs that must be considered as well. Also take into account that as employees leave or retire, the company must have a stock buyback policy which can affect cash flow.
Steps to Implement an ESOP
More small business owners today may find that an ESOP can be an ideal strategy thanks to years of solid economic growth. Knowing how to go about the process and teaming with expert small business strategists is imperative.
- Feasibility Study: Do a deep dive into your business’s financial health. Along with plotting historical profits and cash flows, craft pro-forma financial statements to help decide if an ESOP is in your best interest.
- Valuation: Hire an independent business appraiser who can determine the fair market value of the firm using comparable historical transactions and market-based valuation multiples.
- Plan Design: Work with experienced small business retirement plan specialists to build the right ESOP for you and your workforce.
- Footing the Bill: Given the substantial upfront costs noted earlier, lining up low-cost financing may be needed. You might also elect to put up your own cash to construct the program.
- Legal Documentation: Partnering with lawyers with expertise in small business retirement plans to ensure that you meet all of the IRS requirements is critical.
- Execution: Be sure to set up the ESOT, appoint a trustee, and even establish an ESOP committee within the company as you launch the plan. Funding the plan can be done with a direct contribution of shares, cash contribution, or using leverage to buy shares.
- Relaying the Message: You should be in constant communication with your team regarding why an ESOP makes sense for the business and each worker. Offer ongoing educational opportunities, highlighting the ESOP’s benefits from the employee’s perspective.
The Bottom Line
You care about your workers and the long-term health of the company you have built. An ESOP not only rewards employees with equity claims in the business, but there are also certain tax benefits as well as the opportunity to transition ownership. Though an ESOP doesn’t come cheap, with careful planning and execution, it can boost the long-term health of your small business.
[1] https://www.irs.gov/retirement-plans/employee-stock-ownership-plans-determination-letter-application-review-process
