Employee Stock Ownership Plans (ESOP) are designed to be a win-win for both company owners and their employees.
An ESOP is a trust set up for employers to offer shares or cash for employees to buy into the company. According to the National Center for Employee Ownership, there are about 6,400 ESOPs in the U.S. holding assets over $1.4 trillion for over 14 million participants.
Why are they so popular? ESOPs are an attractive option for owners who eventually want to sell their business, and for employees who have time invested in the organization and are interested in buying into the company to keep the business (and their jobs) in the community. There are tax advantages too. ESOPs are non-taxable, so the company does not pay taxes on their share of earnings and employees do not pay taxes on contributions.
Sounds great, right? In order to make sure your ESOP works as intended, watch out for these common problems:
Creating accurate valuations
One major problem that affects ESOPs is company valuation. Figuring out the fair market value for stock is critical when establishing and maintaining your plan. There are several criteria used to establish this value and it has to satisfy regulations from both the IRS and the Department of Labor (ERISA) as well as meet certain fiduciary responsibilities.
Employees who are considering participating in an ESOP may not have enough financial knowledge about company valuation and could end up paying too much for shares. That can potentially cause problems for both parties.
For example, when a stock price is too high, a company will borrow money against the ESOP to pay the owner(s), who would then receive a sum that is more than the value of the company. Employees who pay too much for stock are saddled with debt and left holding stock that doesn’t have the same value on the market.
Alternatively, shares could be undervalued, leading to unhappy (previous) shareholders who face a dilution of ownership in the company from the new equity capital. The company could also be at a disadvantage when borrowing or raising capital due to the influx of debt often incurred in connection with the inception of the ESOP.
Maintaining cash flow liquidity
When employees leave the company, the ESOP may require a repurchase of their stock at the current valuation. If the company has high turnover, the stock price has appreciated significantly, or there are company layoffs, repurchasing could put undue strain on a company’s cash flow reserves.
This affects the company’s agility and growth. Instead of investing in research or partnerships or raising capital, the company will have to balance the cost of funding stock repurchases instead.
Avoiding problems with your ESOP
Communication, trust, representation and an objective approach are key to ensuring your ESOP is set up to benefit both owners and employee shareholders. Employees who are considering investing in their company via an ESOP should have representation that supports them, informing them of both the pros and cons of ESOPs and how they might affect their personal retirement.
Company owners and leaders should adapt to changing business and industry trends and continue to manage a positive cash flow position. When done well, ESOPs can give fair value to a company, keep employees invested and informed, and adhere to fiduciary responsibilities.
How Wipfli can help
Our teams provide clarity and confidence when evaluating your ESOP. See our ESOP Services web page to learn more or read these additional ESOP articles:
5 reasons companies are choosing ESOP structure
How to avoid biggest mistakes in ESOP valuations
How to manage your ESOP during COVID-19
Developing owner-employees in your ESOP
ESOPs have an advantage during a recession