If you’re a business owner evaluating your options for growth, business succession or exit, it’s worth considering employee ownership and the associated Employee Stock Ownership Plan (ESOP). Depending on your goals and expectations, such an entity structure and ESOP can have notable benefits for you, your employees and your community.

How does an ESOP work?

ESOP stands for Employee Stock Ownership Plan. When you sell your company to an ESOP, your employees become beneficiaries of your company stock and you’re essentially “selling” the company to them. For employees, the ESOP is a qualified retirement plan similar to a 401(k). However, employees don’t have to use their own money to invest.

Sponsor companies of 100% S-Corporation owned ESOPs are tax exempt. Also, owners don’t have to sell the entire company to the ESOP; they also have the option of selling a just a portion. They can even sell it incrementally over time. The portion that is sold to an ESOP will be tax exempt under the S-Corporation structure. Sponsor companies that are C-Corporations have a unique tax planning opportunity for the ownership group when selling to an ESOP potentially taking advantage of Section 1042 deferring capital gains which would be recognized in a traditional sale.

The best candidates for ESOPs are profitable companies that have a second layer of management to continue operations after the transaction.

Considering employee ownership? Our business advisors have over 25 years of experience serving ESOPs.

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ESOP as an Exit or Succession Planning Strategy

An exit strategy that involves an ESOP is more of a business succession strategy than a clean break. By selling the company to employees, owners essentially get to choose their buyers and they get to leave a legacy to their employees.

With an ESOP, the company is more likely to continue its standard operations than it would be with another exit strategy, such as strategic or private equity. There are advantages to all three, but the right business exit strategy for you comes down to your objectives.

ESOPs are ideal when owners want their company to remain relatively the same after they’ve left. These owners typically want to maintain the company culture and offer their employees security of being invested. Many start the process of selling to an ESOP about five years before they want to exit.

With strategic and private equity sales, owners are often selling to an “outsider.” This outsider is more likely to make changes to the company and operations.

ESOP as a Growth Strategy

Most business owners pursue ESOPs for the reasons mentioned above: passing on a legacy, optimizing taxes and maintaining the culture. However, selling to an ESOP can also create avenues to growth. This growth isn’t automatic or immediate, but the tax exemptions associated with employee ownership, and the culture it facilitates, present definite advantages.

First, being an employee-owned, tax-exempt company potentially gives you an advantage in making acquisitions. Organizations with an the S-Corporation structure that are 100 percent employee-owned are exempt from federal income tax. So, when you acquire a company, you don’t have to be concerned with most income tax implications. This can be beneficial for both you and the seller. You can negotiate so that the seller optimizes taxes on their side, and you may get a better outcome because of this. Some companies pursue ESOPs to gain this advantage and make acquisitions part of their strategic plan.

Second, statistics support the idea that employee-owned companies – as well as their communities – thrive and grow due to enhanced culture and commitment. According to the NCEO, companies with an ownership culture that involves employees extensively see growth of six to 11 percent annually over what their previous performance would’ve led to.

Additionally, the NCEO Economic Growth Through Employee Ownership Report states, “employee ownership creates jobs, strengthens communities and expands state economic growth.” Their research revealed that ESOP employees are less likely to be laid off and they accumulate more in retirement assets than employees with other plans. Additionally, companies with ESOPs created more jobs each year than they would have without an ESOP.

Is an ESOP Right for Your Business?

How can you determine if an ESOP is the right choice for your business succession or growth strategy? It all comes down to your goals and expectations. A strategic sale may offer more money and be better for your current needs, but if you’d rather leave a legacy, maintain a certain reputation, optimize taxes and keep the company as it is, an ESOP is a great option. As with any business strategy, you must weigh the pros and cons for your specific business, industry and culture.

ESOPs are seen in a different light today than they were years ago. Initially, there were less rules to govern how ESOPs were formed along with a lack of service providers, resulting in many inconsistencies – particularly in the initial pricing. Today, there are rules in place for forming ESOPs and regulatory bodies are more accepting of them. Bills encouraging employee ownership have even been considered in Congress recently.

States are also getting involved. There are Centers for Employee Ownership in several states (including Minnesota, Ohio, Georgia, Pennsylvania, California and Florida) that offer support to their businesses. Colorado has an Employee Ownership Office which offers loans and grants to assist businesses with transition costs. The Vermont Employee Ownership Center also has a loan program.