An employee stock ownership plan (ESOP) is an employee benefit plan that gives workers ownership interest in the company. ESOPs provide the company, selling shareholders, and participants various tax benefits, making them qualified plans. These plans are formed to facilitate succession planning in a closely held company by allowing employees the opportunity to buy stock. The principle behind ESOPs is to give owners a way to sell their business, or a portion of it, to their employees. It provides incentives to employees to stick around and build the business while also providing an exit strategy for the owners. While there are several benefits of forming an ESOP, there are several pitfalls that a company must consider before creating one.
ESOPs are incredibly complicated and expensive to administer. Even for the most straightforward plan, an owner can expect to pay a minimum of $40,000 to start one. During the life of the plan, the business will encounter legal, administrative, compliance, and trustee fees annually to third parties. There are also transaction fees surrounding the addition of new employees and the retirement of current employees.
These fees and payments, plus the repurchase obligation of an ESOP, means that there is less cash available to invest in growing the business, hiring talent, or exploring new markets. This constant strain on cash flow and liquidity can suppress the business’ ability to invest in growth and innovation, which take a back seat to fund an ESOP.
When an ESOP purchases the shares of a business, it is done based on theoretical valuation reports from qualified firms. This theoretical valuation can be significantly lower than what a competitive selling process could achieve. Although it depends on the business, in most cases, a company can receive a valuation from selling 20-30 percent higher than an ESOP valuation.
ESOPs are extremely complicated and receiving an unbiased opinion about one is challenging because many parties involved benefit from third-party fees. Many plans hire an independent trustee to serve participant interests as well as outside firms to manage plan administration and record-keeping, to avoid conflicts of interest. In addition to this, Fiduciary Liability Insurance is recommended to protect the business against claims of mismanagement of employee benefits.
ESOPs are exceedingly difficult to undo because participants have broad voting and shareholder rights. Any participant can derail or block a fair transaction. Even raising capital is a problem, as new investors often prefer to avoid diluting employees’ shares or open themselves up to lawsuits claiming they undervalued the equity of the company.
Even though ESOPs can provide owners of a company the ability to sell their business to employees when they are ready to retire, many pitfalls need to be considered before forming an ESOP. Whether it’s the high expense of forming one, the fees to third parties, receiving a lower valuation, draining a company’s resources, or because of its complexity, an ESOP can do more harm than good to a company.