Ingram's October 2022

S M A L L B U S I N E S S A D V I S E R

by Ben Williams

Thinking About Creating an ESOP? Things to Note.

Employee ownership changes the workplace dynamic in multiple ways. U.S. businesses are facing a challenging environment. Baby Boomers are looking to transition their businesses, and many business owners are finding it difficult to hire and retain the best talent. Workers are demanding better opportunities, causing companies to rethink their compensation, purpose, and futures. One of the ways we’ve seen many forward-looking companies address these challenges is through Employee Stock Ownership Programs. An ESOP is a type of ownership succession plan that allows a company’s stockholders to sell their shares to the employees of the company. Unlike other methods of business transition, employees pay nothing for their shares. Instead, the ESOP borrows money from a lender (leveraged) or a note from the selling shareholders (unleveraged). Shares are then allocated to employees of the company over time.

such. ESOPs require a company to have ongoing controls in place, such as an an- nual CPA audit. ESOPs also need trustees and board members for oversight. In creasingly, these individuals are required to be parties outside the company, and paying them will add to the ongoing cost. According to the National Center for Em- ployee Ownership, these costs average $20,000to$30,000for smaller companies, with additional costs for larger ESOPs. A second concern for sellers should be the fundamental way the company is operated. Although sellers and key management typically remain with the company, they MUST act in the best interest of the ESOP owners. This can be particularly challenging for small companies and those that have been family-owned. Sellers may be conditioned to pay excessive salaries, use the company for personal expenses, or take unnecessary company trips. Using company funds in this manner could result in valid action or lawsuits against management and officers. Like all business transitions, ESOPs require a business to be profitable. If a company is not profitable, it will strug gle to satisfy the debt and value for the shareholders. Companies with large swings in profitability may not be the best fit for an ESOP. Companies should also consider key creditor relationships before deciding on an ESOP. An ESOP transaction will most likely cause the company to have a deficit equity position for the first few years. Many lenders, bond companies, and other strategic relationships may not be familiar with ESOPs. The sale could negatively impact a company’s future operations if not handled correctly and by parties familiar with these structures. All business owners should explore an ESOP as a method of transitioning their business. Few other methods pro vide a means to improve the lives of employees, maintain company culture, and provide fair value to sellers. ESOPs also continue to be supported by both sides legislatively and should continue to enjoy favorable tax and regulation for years to come.

There are many benefits to a business owner who sells to an ESOP. First, a 100 percent ESOP pays no federal income taxes or state income taxes in most states. The significant tax savings provides the cash necessary to pay back the debt created by the ESOP. Second, an ESOP allows companies to reward their employees while preserving the company’s culture. Unfortunately, this is often lost when employees sell to outside buyers or even family members who do not share the same values. Employees share in the company’s success without having to borrow or spend their own money. In this way, altruistic sellers can help offset the U.S. retirement crisis. Sellers are often pleasantly surprised to see a boost in employee retention,

Few other methods provide a means to improve the lives of employees, maintain company culture, and provide fair value to sellers.

performance, and profitability once employees realize the value of their ownership. In fact, multiple studies have shown that ESOPs outperform other companies. ESOPs also create a market for business owners. This can be very valuable when fair-market value may be difficult to obtain from an outside buyer in industries such as construction and “blue sky” businesses. This can also benefit businesses where family members and other internal buyers are uninterested or incapable of buying the business. One thing to note is that there can be challenges to selling to an ESOP. One of the most cited negatives of this structure is costs. ESOPs require a significant investment upfront. ESOPs require a feasibility study, valuation, tax planning, and legal advice, among other expenses. These can easily cost $100,000 or more for a smaller company and significantly more for larger transactions. Sellers should consider that many of these costs exist whether a company sells to an ESOP or through other means. Although they can be negotiated with sellers, most business transitions involve significant costs to set up properly. Additionally, ESOPs involve significant ongoing costs. The ESOP is a government-approved retirement plan and must be treated as

Ben Williams is surety director for Holmes Murphy in Kansas City. P | 816.857.7800 E | ben.williams@ holmesmurphy.com

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Ingrams.com

October 2022