ESOP – employee stock ownership plan, is a qualified employee benefit plan which provides employees of a business an ownership interest in the business. ESOP’s are used by employers to reward employees, or as an exit strategy from business ownership. If owned by a plan, the business can potentially get a lot of great tax benefits.
Let’s talk about how a employee stock ownership plan works first
A employee stock ownership plan is employee benefit plan which is established by the owners of a company. When you use a plan, the plan essentially either borrows funds, or gets contributions from the company. These funds are then used to purchase shares in the business. It’s a great way for business owners to transfer full or partial ownership of the company to employees and get a number of tax benefits.
When a business owner establishes an employee stock ownership plan as a retirement benefit for their employees, they create an esop plan which outlines the structure, and the policies. In addition, they appoint a trustee, or a committee, which then oversees the plan. It’s typical for one of the company employees to be appointed in order to represent the employees. Many big companies like OnDeck are using this type of financial planning tool.
Every plan document has limits. For example, business owners can transfer full/partial ownership of the company to employees with either voting or nonvoting shares. Using this type of structure, business owners can keep control of the company until the employee stock ownership plan buy all of the shares.
ESOP Benefits For Employees
Employee Stock Ownership Plans are a great perk for eligible employees. The eligibility is typically outlined in the plan. The maximum age an employer can impose to be eligible for an employee stock ownership plan is 21. The employees must be eligible for the employee stock ownership plan within 1 year of joining the company. Employers can restrict the eligibility to employees with two years of service, but only if the plan has an immediate vesting schedule. One of the biggest employee stock ownership plan benefits for employees is that an employee stock ownership plan gives employees the ability to get shares in the business without contributing any of their own money. Instead, a company will make contributions every year which are used to buy shares, or repay a loan, which was used to buy shares.
The main reason employers consider this is the fact it’s a business transition tool. In the absence – an employer has only two options: sell the business, or gradually take money out of the company and shut it down. By using this, the company can continue and the owner can play any role they want going forward. The owner of the company is able to defer taxes, and reinvest the gains in other securities.
With this, owner’s don’t have to sell everything at once. They can sell out some now, and some later. Or, one owner can sell, and another can hold. This only work for companies that have enough in profit to purchase shares + still run the business. They are not worth doing in companies with 20 or less employees due to the cost and complexities involved.
Types of Employee Stock Ownership Plans
There are three types of most employers use to transfer full/partial ownership of a company to the employees. The plan document governs the plans including the type it is.
Three primary types of esops are:
Unleveraged: These are the most basic type of employee stock ownership plans. When you use an unleveraged plan, a company is making periodic contributions to the plan, which is then used to buy shares in the company from current owners. Unleveraged is ideal for a business owner who wants to be bought out over time. It’s a great plan and great way to reward an employee who stays with the company over an extended period of time, instead of the employees who are with the company at a singular point in time.
Leveraged: In this type of employee stock ownership plan, the plan takes out one or more loans from a bank or other lenders. The borrowed funds are then used to buy shares in the company from the owners of the company. The company makes regular contributions which are used to repay the loan taken out. Leveraged are very common, and are a better option for business owners who really want to be bought out quickly. When you use a leveraged plan, the business owners can structure a loan for the the plan to buy a large number of shares in the company all at once – rather than in little pieces over time.
These are the least common types. Companies who are using an issuance make regular contributions to the plan which is comprised of newly issued shares of company stock instead of cash. An issuance is a fantastic choice for business owners who don’t want to contribute profits to the employee stock ownership plan but instead want to issue new shares to the plan. Using the structure, current owners of the business have the ownership shares diluted over time as the number of outstanding stock shares increases.
ESOP Benefits for Business Owners
ESOPs are a great benefit business owners don’t want to to focus on finding a buyer for their business. Business owners can use one to create a buyer for their company right right from their employees. They are great to help attract employees and it helps reward long-time employees for their dedication and service.
They are useful for a number of situations like:
Attracting talent: When you have one it’s great because you can hire more attractive talent without having to pay extra money. This is great for recruiting!
Reward employees: If you have employees that have been with you for years, then having one is a great way to reward them for their years of dedication and service.
Transfer control of a business: They are a great way to allow business owners to create a potential buyer for the company via their employees.
Low-cost to employees: Employees don’t have to participate in one unlike a 401k. Businesses cover the costs of one and make the contributions to buy company stock from the existing business owners.
When you use this, business owners can make contributions to the plan each year which are tax-deductible – up to 25% of the company’s payroll. Business owners can also have it borrow money in order to buy shares in the business. It’s a win-win scenario!
One of the biggest benefits for small business owner is the tax benefits. If you are a C-corp, then any profits paid to the ESOP as dividends are tax-deductible. Once the plan owns 100% of the business, then the business is exempt from corporate income taxes.
When shouldn’t you use an ESOP plan
They are a great benefit for small businesses, but aren’t ideal. They don’t work for very large companies that cost too much to buy, or super small businesses with just a few employees, or with businesses that have trouble retaining employees. Here are some instances where they aren’t a great idea.
Large companies: Very large, or publicly traded companies are often too valuable for to purchase over time.
Very small companies: Super small companies with low revenue or few employees often aren’t worth the cost of setting up one.
Multigenerational businesses: If you have a company which has been family-controlled for many generations, you might want to make sure that the stock ownership and voting rights stay in the family.
Retirement asset businesses: If you depend on the sale of your business in order to finance your retirement – then isn’t a good idea – because it uses company profits in order to finance the buyout.
One of the biggest reasons companies elect for one is the tax treatment you get. When you use one, businesses can make contributions to the plan which are tax-deductible for the employer. It allows business owners to reward employees while reducing the tax burden.
How Employee Stock Ownership Plans vesting schedules works
Employers that offer this – choose the schedule for vesting shares that employees own. Vesting schedules are outlined in the plan document, and if you leave the company before you are fully bested – then you forfeit some of the stock. The IRS usually requires that employees be fully vested – after 6 years – depending on the type of vesting schedule setup. Under Section 411 of the internal revenue code, employers who use vesting can choose from 2 different types of vesting schedules. Under graded vesting, employees are vested in event amounts over many years, but must be fully vested in 6 years. Employees with a cliff vesting schedule have to vest all at once, within 3 years.
Vesting Minimum Requirements
|Cliff Vesting||Graded Vesting|
Employees whose plans are dictated by vesting schedules can vest faster than the minimum requirements – but cannot vest slower. Vesting doesn’t occur for each year individually, but all at once. If an employee covered by a cliff vesting
Employees whose plans are subject to an schedule can vest faster than the minimum requirement but can’t vest slower.
There are some minimum vesting requirements that businesses have to meet in order to use this. Business owners can have faster vesting schedule in their plan document. Some immediately vest stock owned by an employee via the plan. The shares – however can be sold at any time or kept if an employee leaves the plan.
Taxes for employees are usually really low. Employees don’t pay any taxes on employer contributions to the plan. There’s no tax implications due to the fact the employees accumulate ownership through the this. The only taxes the employees pain in an employee stock ownership plan are on the profit distributions. The individual IRA eligible participants can sometimes roll the distributions into an IRA in order to grow tax free.
Employee Tax Considerations To Think About
No taxes on employer contributions: Employer contributions of either cash, or stock, or tax-deductible to the employer up to 25% of the total payroll. Contributions also aren’t taxable to employees.
No taxes on contributions to repay loans: If your plan has to borrow money in order to buy shares in the business, then the contributions used to repay the loan aren’t taxable for employees. The contributions are also tax-deductible for employers.
No taxes on ownership % that accumulates: As employees build ownership in the business – there are no taxes on this increased % ownership.
Taxes on profit distributed: Employee distributions are taxable but can be taxes as capital gains instead of income or rolled into an IRA with all of the taxes now being deferred.
Employee stock ownership plan distributions are subject to SOME of the rules as IRA distributions. It means that in addition to the income, or the capital gains taxes on distributions, the employees are also subject to a 10% penalty if they take distributions too soon.
Employee Stock Ownership Plans Tax Benefits for Small Business Owners
The plan offer a lot of tax benefits to small business owners. When you use an esop, employers can contribute either cash or stock which is tax-deductible for the business. The biggest tax benefit of this is that if a business is owned completely by a plan – then it’s also exempt from corporate income taxes. In addition to tax-deductible contributions, business owners can also get other tax benefits by selling their stock to it. For example, business owners can defer capital gains from the sale of stock to a plan – once the it owns more than 30% of the business. In order to o this, company business owners have to reinvest any money they earn when the employee stock ownership plan ends up purchasing their shares.
Rules and Regulations
If a business owner offers this, there are rules which have to be followed in order to make sure it isn’t disqualified. When you structure one, business owners have to offer a vesting schedule which meets certain standards. Business owners also have to enroll employees who become eligible for the plan. If you have a plan through work, you should make sure the business owner is following the rules of the plan carefully. If the owner fails to follow the rules, it can cause your plan to be disqualified, or the employer to incur penalties!
Rules For Business Owners
In order to use it, employees have to make sure that their employers are following the rules. For examples, business owners have to enroll all of their eligible employees. The owners contributions to it are limited based on the company revenue. Contributions are usually capped at 30% of earnings before EBITDA. Here are some important rules you have to follow:
- The contribution limits are capped at 30% EBITDA
- All eligible employees must be enrolled
- You have to follow vesting guidelines
- You have to pay taxes where applicable
- Employees must have a trustee appointed to represent the interests of the employees
- Meet vesting schedule – employers can either use a cliff or graded vesting schedule. Employees have to be vested no longer than a 3 year cliff, or 6 year graded vesting period
If you work for a company which offers it, then it’s important your employer follow the rules. If your employer violates the rules, then the plan can run into penalties or other tax liabilities.
They can be very expensive to setup. One of the biggest advantages of an employee stock ownership plan for employees is they pay almost none of the cost. The biggest cost employees incur from an employee stock ownership plan is that their stock ownership plan can take the place of cash bonuses or profit sharing. Businesses pay the costs of record keeping, financial advisors, etc, who structure the transaction and the costs of the contributions. The costs must be paid before either company the company owners or the plan get profit distributions from the company. Below are some costs of a plan.
Setup Costs: ~ $75,000
Business owners have to pay legal fees and appraisal costs to setup it up. These fees drastically increases the first year costs of the plan.
On-going Administration: $20,000 annually
Maintaining one requires an annual review, as well as representation by a trustee whose job is to protect the participants of the plan.
Recordkeeping: $2000 to $6000 plus a fee per employee
In order for it to be valid, you have to keep detailed records of the contributions to the plan as well as stock as stock purchases, and the vesting schedule of each employee.
Contributions: Discretionary for employer
Most employers setup an Employee Stock Ownership Plans and provide regular contributions each year for a period of time. The contributions are decided by the employer.
Contributions are tax-deductible up to 25% of the total payroll. The contributions aren’t taxable to employees. Employee distributions though, are taxable, but those taxes can be deferred if the employees roll the distributions into an IRA.
Financial Advisor Fees: 1-3% of the transaction size
This is an optional cost. Many employers have financial advisors in order to setup the buyout. While employees don’t pay the costs directly, it’s important to be aware of them and how the costs work.
In an employe stock purchase plan, employees contribute to the plan with salary deductions. It’s like a 401k. The contributions are used to purchase stocks in the company at a discount. Unlike an ESPP, employee stock ownership plan’s don’t have employee contributions. Instead, employers make tax-deductible contributions in order to buy company owners’ stock for the plan. Employees don’t usually get a choice between an employee stock ownership plan or ESPP. Instead, an employer chooses one and sets it up for the employees. Employers who choose an ESPP – should be willing to accept lower plan participation since ESPPs require contributions from employees or be willing to sell only a part of the company. When you use it, company owners have to contribute the money for the employees to buy their companies. They can also control the pace and structure of the companies prospective sale.
Pro’s and Con’s of a Plan
They are a great asset to employees. Employees can build an ownership stake in the business with no real personal costs. The costs are entirely on the business itself. Business owners get to make tax-deductible contributions, and can use one to attract talented employees.
Pro’s of a Plan
For an employee this is a great tool. Employees can get free shares in a company which they can sell at a later time. Costs are high, but the business handles all of them. Employees can also eventually take over operations and running of the company when the buyout is complete. They are great for recruiting, and the biggest reason business owners love them is the tax benefits.
Some benefits include no taxes for employees – which means there are no taxes on the plan contributions, only on the distributions which can be deferred if you roll them into an IRA. There’s also no cost to employees! Employees pay virtually none of the costs of it – unlike a 401k – where some of the contributions are used to cover the employee stock ownership plan plans administration costs. In addition, it has a built-in buyout – where employees who have access to a plan don’t have to wonder if they can buy the business. When you have it – it’s all setup inherently.
Cons of this plan
There are literally no drawbacks for employees. The plan can take the place of a cash bonus, or profit sharing. The biggest drawback of this plan is the high cost to employers.
Here are some cons of this plan: employees may not have control even though the employees will be invested in the business through the stock plan. The plan, if setup correctly, doesn’t need to grant rights or decision making power to the employees. It makes it difficult or impossible for employees to protect their investment into the company. In addition business owners have to make sure the business is run in a way which benefits the employee stock ownership plan. Owners of businesses have a fiduciary duty to the shareholders/employees of the plan – which means they have to run the company for the plan’s benefit and can’t take excess compensation.
How to setup an employee stock ownership plan
Setting up an employee stock ownership plan doesn’t require any input from employees. Employers decide whether to setup a plan, and employees can decide whether they want to participate. If your employer offers an employee stock ownership plan, it’s up to you to familiarize yourself with enrollment qualifications and make sure you’re able to enroll when you’re eligible. Below are the four steps business owners have to go through in order to setup a plan:
- Choose an Provider – Setting it up requires hiring an attorney and appointing a trustee to represent the employees in the plan. While some business owners can setup using their attorney and their financial advisor.
- Draft / Adopt a Document – Once you choose a provider, the business must work with their attorney / provider to prepare a document. The plan documents outline everything about the plan, including eligibility criteria, etc. It must also designate a trustee to represent employees in the plan.
- Enroll Eligible Employees – After a plan document is drafted, and adopted, employers have to enroll all employees who are eligible to participate. Qualifications for the employee stock ownership plan are in the plan document. Employers have to be careful not to exclude employees who are eligible for the plan.
- Make Cash or Stock Contributions – When the plan document has been formed, and employees have been enrolled, the last thing left is to administer it. This can be done by having it borrow money in order to purchase stock in the company and then making tax-deductible contributions which can be used to repay the loan. Employers can contribute stock directly into the plan, or contribute cash, which can then be used to purchase the shares.
If you choose to use a leveraged plan, the steps are basically the same except for the administration of a plan. Under a typical unleveraged employee stock ownership plan, a company can make contributions which are used to purchase stock shares of the company over time. In a leveraged employee stock ownership plan, the process is reversed. The Employee Stock Ownership plan borrows money, which are then used to buy shares of the company. The company makes contributions over time in order to repay the loan.
Employee Stock Ownership Plans Frequently Asked Questions
A employee stock ownership plan is different from a 401k. In a 401k, the employees contribute through salary deductions which they invest into stocks and bonds etc. They also get employer matching, and profit sharing contributions. This is like a 401k plan, but it gradually shifts ownership from the companies owners to its employees.
Distribution is a withdrawal that employees take from the account after they vest. Distributions are taxed as ordinary income, but can be taxed as capitals gains in some instances. Distributions can also be deferred if the employee rolls the distributions into an IRA.
Vesting periods are timeframe where an employee must wait until the stock in their company is vested. Employee stock ownership plan vesting is similar to a 401k vesting schedule. It’s part of the employee stock ownership plan plan.
Leveraged is a plan which takes out a loan in order to purchase company stock from the owners of the business. With a leveraged plan, employer contributions are used to repay the loan over a long period of time.
Can I cash out my employee stock ownership plan?
An employee stock ownership plan allows you to get your company’s stock as a retirement plan perk. Should you have reached the retirement age, or have become disabled, you can expect distributions to start that year, or the year after. Your beneficiaries can also receive the distributions if you die. By law, your company has to send you an annual statement reporting the amount of cash in your employee stock ownership plan account. The human resources department can provide you with a copy. The number of vested shares is those you keep after you have left the company. Vesting happens in one of two ways. No vesting may happen in the initial years of your employment.
If you’re quit or laid off, employee stock ownership plan distributions are deferred for six years. Once those six years pass, you can receive the value of your shares in one lump sum, or in equal payments made over five years. The installment payments are limited to 6. The lump sum distribution can consist of shares, stock, or a combination. If it is done in installment over five years, you can receive the annual portion in the form of stock. It also means you cannot receive all of your employee stock ownership plan funds for up to 11 years after you quit your job.
Each employee stock ownership plan has a distribution policy which is included in your employee stock ownership plan document. Some plans can have a lump sum threshold. If the vested amount exceeds the threshold, you will go into an installment route.
ESOP Retirement Account Transfers
If you don’t want to pay the IRS a 10% penalty on early employee stock ownership plan withdrawals, as well as regular income tax, you must transfer/roll over the money from your employee stock ownership plan shares into another retirement account – such as a traditional IRA. Once you are 59.5 you can withdraw the funds and avoid the penalty. The distribution is taxed at ordinary income tax rates though. You don’t have to make withdrawals from a traditional IRA account until 70.5.
What happens to employee stock ownership plan when you leave Company?
If your company has an employee stock ownership plan, you own shares of the company’s stock as a retirement benefit. IF you quit, you only get the amount of stock that has been vested, or given to you during your tenure. When you quit, you only have to wait for the company to distribute the stock to you. Once your shares are available for distribution, you can request the cash value of the shares.
First, look at your employee stock ownership plan statement. It shows you how many shares you have, as well as the date that other shares will be vested. Check the employee stock ownership plan statement for information on how long you have to wait until the shares can be distributed. If you can’t find it, contact your human resources department. Once you find out, request the distribution forms from your employee stock ownership plan company. The forms will transfer the shares from from the ESOP to you. You will need these forms to complete the transfer. Once you get the shares, you can sell them using your broker or an online brokerage house.
Can employee stock ownership plan money be rolled into a 401k?
Employers offer workers Employee Stock Ownership Plans which are based on annual profits. They are different than employer-sponsored retirement plans like 401k. An employer can maintain both plans for employees to receive the tax breaks an employee stock ownership plan plan offers, and the diversification offered by a 401k. Moving an Employee Stock Ownership Plans stock to a 401k is contingent on both plans accepting the transfer.
If you want to transfer your employee stock ownership plan stock to a 401k, you must first contact the administrator. You can find this info by looking at the employee stock ownership plan annual statement. Explain you want to transfer the stock into a 401k plan and find out if the plan allows it. Request the necessary paperwork. Contact your 401k administrator and ask if the plan will accept a transfer/rollover from the Employee Stock Ownership Plans. The IRS allows this transaction, but the final decision is up to the administrator. After you get approval, fill out the paperwork and make copies for yourself and the administrator. Mail the employee stock ownership plan paperwork, with a copy of the 401k paperwork, to the administrator. Then do the same for the 401k administrator.
Is an employee stock ownership plan a good idea?
Employee Stock Ownership Plans are a potentially great idea. But they can be risky too. Employee Stock Ownership Plans increase the concentration of your retirement income into one single security – your company’s stock. Critics contend this reduced diversification make Employee Stock Ownership Plans risky. Even worse, employees are depending on the same company for their paycheck AND retirement account. This is an understandable concern. Based on Department of Labor filings, companies on average contribute 50-100% more to ESOPs than non-employee stock ownership plan companies do to 401k plans. The increase in investment helps stabilize the company. Most of the money in a 401k plan come from the employees. All the assets in an employee stock ownership plan usually come from the company. According to the Department of Labor, ESOPs have a higher rate of return than 401k plans, and are less volatile. In addition, employee stock ownership plan’s lay off less people than non-employee stock ownership plan companies – moreover, they cover more employees, especially younger/lower income employees than 401k plans. Some people say employee stock ownership plan’s are riskier than 401k’s, but according to public data the majority of employee stock ownership plan’s are funded entirely by the company. Employee stock ownership plan participants accumulate large account balances, well over 6 figures, after 10-15 years. If the value declines, then employees suffer a real loss. But it takes a long time for employees to accumulate enough stock to suffer those losses potentially.
Are ESOPs good for employees?
When your employees are part of a plan – it provides unique rewards for your employees. Participants in a plan can get significant retirement benefits at no cost to them. Research shows that companies that have an employee stock ownership plan are more productive, faster growing, and more profitable. Moreover, they have lower turnover. The benefits of this plan accrue to all shareholders in their retirement account. In addition, an employee stock ownership plan is a fantastic way to recruit better talent. Bottom line, these plans encourage employees to communicate and think like business owners.
Is a employee stock ownership plan better than 401k?
Employee stock ownership plans allow businesses of all sizes, including S corps and C corps to make employees owners of the company. It gives business owners a method to sell their company without having to procure a buyer. One of the questions some people have is whether it’s better than a 401k plan. Like other retirement plans, an employer’s contribution to an employee stock ownership plan plan is allowed to grow tax free until the funds are distribution upon retirement. One of the great things about an employee stock ownership plan is that you can sell the stock, and then roll them into another qualified retirement plan – such as an IRA or a plan sponsored by another employer. Another provision of an employee stock ownership plan gives participants – the option of diversifying their employee stock ownership plan away from company stock and towards traditional investments. Only 1% of employee stock ownership plan’s have gone under financially in the last 20 years. One of the great things about an employee stock ownership plan is that workers don’t have to contribute financially to participant. The share’s value is determined once a year by an outside trust company, based on the company’s growth. The shares are then given to the employee’s account. The average employee account balance in an employee stock ownership plan is $134,000. One of the main reasons why employers prefer an Employee Stock Ownership Plans to a 401k, is because it’s a motivation tool for employees. It allows owners to transfer ownership to the employees, and it helps them improve their performance since they feel they are part of the ownership of the company. When a company gets an employee stock ownership plan, it also comes with tax breaks. When an employee stock ownership plan purchases the shares of a company, it isn’t required to pay federal or state income taxes. This is contrast to a 401k.
How does employee stock ownership plan vesting work?
Employee stock ownership plan vesting is a concept many participants must be familiar with. Vesting refers to the amount of time an employee has to work before getting stock benefits. Employees who leave the company before being fully vested forfeit their benefits. Employee Stock Ownership Plans must comply with one of the following schedules for vesting – some plans can provide different standards if they are more generous.
- No vesting in the first few years, followed by a sudden 100% vesting after no more than 3 years of service
- 20% vesting after the second year of service 20% more each year, until 100% vesting occurs after the 6th year of service
Year of service refers to a plan year in which a participant has a minimum of 1,000 hours of service. If an employee leaves before they are fully vested, the amount is forfeited. It is reallocated to remaining participants.
Benefits are usually paid to participants after their employment is terminated, whether because of retirement or other reasons. When a participant retires/is disabled/dies, the employee stock ownership plan has to begin to distribute vested benefits during the plan year unless there’s an exception.
When an employee stock ownership plan participant’s employment terminates for reasons other than retirement, disability, or death, the distribution may wait a while. The participant has to be given the right to start distributions no later than the 6th year plan after the plan year when the termination occurs.
How much does it cost to set up an Employee Stock Ownership Plans?
An Employee Stock Ownership Plans comes with many benefits, but the cost of setting one up is complex. The benefits of enabling employees to become partial owners has many tax benefits. The cost can be at least $20,000. Below are the steps that will occur and how much each step costs.
Feasibility Study: The first step is seeing if it’s even feasible or not. Companies as small as 20 employees can be candidates for an Employee Stock Ownership Plans. Many questions must be answered first. The most basic is whether owners are willing to sell. Other questions include whether your company’s cash flow will support the requirement of the plan. You have to hire an account who specializes in feasibility studies.
Valuation: Next you have to find out how much the company is worth. Comprehensive valuations for an employee stock ownership plan can cost $10,000 or more.
Attorney Fees: Legal fees often represent the bulk cost of setting up an employee stock ownership plan. The employee stock ownership plan legal team is responsible for reviewing all the plan documents, and reviewing the plan’s designs.
Funding: Getting the cash to purchase shares in a company is another expensive part of the process. This is done through a loan. There are many fees for the legal opinion, loan prep documents, loan commitment fees, etc.
Annual Costs: The first year will involve some ongoing costs, like record keeping, distributing account statements, regulatory filings, etc. You should expect to pay a fee per employee, with larger firms paying less per worker, and annual continuing administration costs.
12 Reasons Why an ESOP is a Terrible idea
An ESOP is an Employee Stock Ownership Plan used by companies with private equity as an exit strategy rather than sale or acquisition. Essentially, the idea behind an ESOP is to give employee company stock as part of their remuneration package or added benefits so that the company can remain within the control of the employees where a shareholder wants to exit. They are set up by establishing a trust fund into which the business entity puts in newly issued company shares or money to purchase existing company shares. In most cases, business entities borrow to finance this venture.
In the US, ESOPs are recognized as tax-qualified retirement plans and therefore governed by the Employee Retirement Income Security Act of 1974 (ERISA). Contributions to the ESOP kitty are deductible from a business’ annual tax bill.
For closely guarded private firms, ESOPs might be a better succession planning tool than acquisition or sale. However, the risks involved in managing and operating an ESOP far outweigh the benefits. These disadvantages include;
1. It is a complex process
Setting up an ESOP is complicated. It involves a lot of government agencies, paperwork and is subject to a ton of regulations. For starters, a company desirous of setting up an ESOP has to set up a trust. Contributions have to be made into the trust annually with keen oversight from the IRS and Department of Labor. The trust also has to conform to ERISA guidelines strictly. The contributions made into the trust are then appropriated into different employee accounts only after vesting. Besides, there is a lot of legal work to be done.
2. It is expensive
Generally, initial setup costs may set back the company at least $100,000 to $150,000. This is dependent on the size and complexity of the transaction. Remember that these amounts only relate to the annual contributions. Legal costs also add to the bulk of expenses required to make an ESOP fully functional. Moreover, the company also has to retain a financial advisor and an independent trustee.
3. It is not ideal for cyclical businesses
Cyclical businesses occasionally experience downturns. When this occurs, employees may be laid off. If there was an ESOP set up, the company would have to fork outwards of cash to buy back the laid-off employee’s stock. Moreover, since ESOPs are often leveraged against debt, the company may be in trouble when lenders demand satisfaction of debt during a a downturn.
4. Deals a blow to Cash Flow
The money used to set up and operate an ESOP reduces the operating capital of a business. This negatively affects cash flow leaving the business with little money for its day to day operations.
5. Succession may fail
The main reason why companies opt for ESOPs is for succession planning. However, where there is no suitable successor in place, the company then lacks the talent of management and entrepreneurship. This problem is amplified by the fact that the company has diluted liquidity as a result of the ESOP.
6. Decreased valuation
In case the ESOP trustees, that is, the employees, exercise their rights to redeem their stock, there is a potential risk of dilution of existing stock value. Moreover, the price of the stock in an ESOP is limited to fair market value.
7. Corporate governance issues
The initial set up of an ESOP takes time and is prone to delays due to bureaucratic hurdles. ESOP trustees may develop impatience and opt up of the scheme before set up is complete. In this case, it will be prudent to readjust the ESOP, causing more delay.
8. Fiduciary obligations
The scheme comes with a lot of fiduciary obligations that require utmost disclosure to all beneficiaries of the scheme. Breach of fiduciary duties may expose the business to legal claims that may cost the business money in damages or hefty taxes in the case of inflation of stock prices.
9. The terms of the ESOP may be incompatible with employee wishes
Where the scheme is packaged as part of the employee’s remuneration package, employees may be hesitant to take pay cuts and benefit rollbacks.
10. Implementing some of the ERISA guidelines may be difficult
Section 409(p) of the ERISA guidelines, for instance, prohibits a single individual or family from receiving too many share allocations in the scheme or any other equity issued by the company. This would not sit well with members of a family working in the same corporation.
11. The scheme is not a good fit for small businesses
With all the intensive investment to run an ESOP, the scheme may not be viable for a small business with 10 to 15 employees. In this case, the costs of maintaining the scheme will outweigh the benefits of tax deductions.
If an ESOP fails, employees may lose their jobs along with any benefits accruing from the scheme. In summary, an ESOP is a delicate process that can only be pulled off with intensive monitoring and huge operating capital. Anything short of that can result in total mayhem.