ESOP Pros and Cons List
ESOP stands for Employee Stock Ownership Plan. The most common reason to use an ESOP is when the owner of a private company wants to retire. If selling the company outright to another party is not a desirable option, and ESOP can be used to keep the company going. There are many advantages to ESOPs, but there are also substantial disadvantages that need to be evaluated before a final decision can be made.
List of Pros of ESOP
1. Tax Benefits
One reason an owner may choose to liquidate his or her shares through an ESOP is because of the many tax benefits that are associated with such a move. There are several conditions that must apply, but as long as these conditions are met, the owner may qualify for a tax free rollover on any money that they get for their shares. The corporation who sponsors the ESOP also gains significant tax benefits. Any money that they pay into the ESOP is tax deductible. For federal and state taxes combined, this totals up to 40% savings for most corporations.
2. Company Perpetuated
For many people who have opened their own business if they have no children interested in taking over the company, they must close their doors when they reach retirement age. Using an ESOP is one way to keep the company running. This is a great advantage to the owner(s) who want to see their business continue on into the future, even if they are no longer at the helm. Employees obviously benefit greatly as well, as they will not find themselves searching for a new job.
3. Prevent Takeovers
One reason to form an ESOP is when an owner wishes to liquidate and there are no buyers interested in his or her shares. But an ESOP can also be formed when there is an interested buyer who wishes to reformat the company or merge it with another company. When there is no competition for this buyer, an ESOP can create a second buyer by dividing the shares among company employees and therefore keeping the company independent and in friendly hands.
4. Employee Equity
In a successfully implemented ESOP plan, employees receive dividend income for their shares in the company. The corporation contributions to the ESOP are almost always larger than 401(k) matching plans or profit sharing. In addition the increased income for the employees, this equity also increased team unity and loyalty. Once employees share in the equity of the company, they are much more motivated in their work and turnover rates become much lower.
List of Cons of ESOP
1. Buying Obligations
Privately owned corporations are obligated the buy back shares from ESOP participants who die, retire, leave the company, or for any reason cease to participate in the program. This can create a drain on the corporation’s resources if funding for this obligation is not carefully planned for ahead of time. This repurchasing liability generally does not become an issue until 6 or 7 years after the ESOP is formed, making it easy to overlook in the initial planning stages. Instead of saving the company, a poorly planned ESOP often ends up bankrupting the corporation and driving it into the ground.
2. Governance Issues
It may be necessary to reorganize the governance of a corporation once it becomes an ESOP. This can be a long drawn out process with far reaching implications. With greater attention being paid to private companies following proper governance procedures, ESOP corporations must take care to be in compliance at all times. One of the newer regulations states that ESOP participants in privately held companies hold voting rights on seven issues which are mergers, consolidation, recapitalization, reclassification, liquidation, dissolution, and sale or trade of majority assets. In any of the issues arise, participants must be given the opportunity to cast their vote, which is weighted in accordance with the number of shares that they hold.
3. Employee Ownership
Owners who decide to form an ESOP solely for the tax benefits are overlooking one of the largest issues that need to be addressed in the planning stages of an ESOP. Employee ownership needs to be cultivated rather than dumped into everyone’s laps. The benefits of an ESOP need to be clearly communicated to all of the participants and an ownership culture developed in order for an ESOP to reach its full potential. This requires a great deal of effort on the part of the corporation to educate employees about all facets of an ESOP and a willingness on the part of employees to change how they think about the company.
4. Consequences of Failure
An ESOP is only as good as a company’s stock. Employees are taking a huge risk when they agree to participate in this plan. If an ESOP is caught in violation of regulations, such as not paying fair market value for repurchased shares, the resulting penalties can be devastating to the company. Should the corporation be forced to declare bankruptcy for any reason, employees find themselves out of a job. Even worse, the shares that they had been counting on for retirement plans and other savings are now worthless. When as ESOP fails, all of the participants take a very hard hit. The risks of this must be considered before anyone signs on to the plan.
An ESOP is a viable option to keep a company independently operating after the owners decide to liquidate. There are many complex issues surrounding the formation of an ESOP, however, that must be fully understood before this step should be taken.