For many private businesses, instituting an employee stock ownership plan, or ESOP, can help provide a means for succession while giving employees a vested interest in the company’s overall success.
Presently, there are almost 7,000 ESOPs covering more than 14 million employees, according to the National Center for Employee Ownership (NCEO).
That number may grow thanks to the federal Main Street Employee Ownership Act, signed into law in August to make it easier to finance the transition to an employee-owned business.
“This is one of the more significant pieces of ESOP legislation in quite awhile,” says Jim Terez, associate director of the New Jersey/New York Center for Employee Ownership at Rutgers University. “We think it will have a positive impact on encouraging some companies to start ESOPs.”
In particular, the law updates Small Business Administration lending practices under its 7 (a) loan program to make it a less cumbersome ESOP financing tool, he says.
This includes aligning 7(a) lending with commercial industry practices so an ESOP loan guaranteed by the SBA can now be made directly to the company rather than strictly to the ESOP trust, giving the company more flexibility on how the ESOP operates, and allowing such loans to be made under the SBA’s Preferred Lenders Program, which enables a more streamlined loan application process and expedited approval, says Terez.
In an ESOP, companies set up a trust fund and contribute either cash to buy company stock, contribute shares directly to the plan, or have the plan borrow money to buy shares, according to NCEO. The trust buys shares of the company from the owner on behalf of employees as a means of buying the owner out.
“The conversion to an ESOP is often debt financed from a bank,” says Paul Becht, a partner at Margolin, Winer & Evens, LLP in Garden City, a CPA and business advisory firm.
The company must then pay back that debt, which means the business should be currently profitable and confident it will remain profitable for the foreseeable future, he says.
Shares purchased from the owner are allocated to individual employees’ accounts often using a formula based on their compensation, says Becht. If an employee leaves or is terminated, benefit distributions from an ESOP may be made in cash or company stock and are based on how much the employee has vested in the plan, he says.
An independent valuation firm is used to set the value of the shares annually, says Becht. The better the company does, the better the valuation generally, he says.
“If a business is cyclical or subject to profitability fluctuations, it may not be a good candidate for an ESOP,” says Robert Grote, a partner and manufacturing/distribution practice leader at Grassi & Co. in Jericho, a CPA and business advisory firm.
Also to be considered are the costs to establish an ESOP, which can reach six figures depending upon size and complexity, he says, noting he worked on an ESOP that cost more than $500,000 to establish. There are also annual maintenance costs, such as the independent valuation, which can range from $10,000 to $20,000.
Still, an ESOP has its perks, offering certain tax advantages. For example, company contributions into the ESOP are generally tax-deductible, says Grote.
It also allows the business to stay intact rather than if, say, it was sold to an outsider, he says.
“It allows the vested stakeholders that know the business to stay in the firm,” says Patricia Sileo, human resources director at Bohemia-based P.W. Grosser Consulting, Inc., which started an ESOP in 2016. Now 10.4 percent of the company is owned by the ESOP, but the firm hopes to continue to buy 5 percent each year going forward as part of a long-term succession plan, says Bryan Grogan, a senior project manager and an ESOP trustee.
Moving forward, there will be an education curve.
“Based on the recent legislation, the SBA is reviewing and considering what changes may be necessary in regulations or procedures,” says Dianna Seaborn, director of the SBA Office of Financial Assistance. “SBA will then issue any changes through official notice to the public.”
Average wealth accumulated by workers with a stake in an Employee Stock Ownership Plan
Source: Research by professors Joseph Blasi and Douglas Kruse of the Rutgers Institute for the Study of Employee Ownership and Profit Sharing