ESOP Pre-Feasibility Toolkit and Tax Advantage Calculator
Considering an ESOP? The process can seem daunting at first, but we’re here to help.
We have developed the Pre-Feasibility Toolkit as a collection of resources to help you determine if an ESOP is right for you and, if so, what steps to take next.
This toolkit includes readings, webinars, ready-to-use sample documents, resource lists, and research that draws on the NCEO’s decades-old history of talking with business owners, conducting research, and distilling common lessons and best practices into an easily usable format. Each section has embedded links in the articles that we recommend that you read. At the end of each section, there are additional links to explore an issue in more depth.
Going through this material will help you decide if it makes sense to take the next steps with an ESOP. When you are done, you will know:
- If your situation meets the basic requirements to make an ESOP practical
- How well the benefits of ESOPs match your goals
- The pros and cons of the major types of ESOP transactions
- The steps in creating and funding an ESOP
This toolkit does not replace the need for an ESOP feasibility study, which may be an important next step. If a formal ESOP feasibility study makes sense, this guide will help you get started with designing an RFP for a feasibility study and selecting some providers to bid on that RFP.
You may determine that an ESOP is not the right fit for you or your company, or that now is not the right time. The Pre-Feasibility Toolkit is designed to help you make that determination as quickly as possible and to give you ideas for alternative approaches that may make sense. These may include other forms of employee ownership, such as giving everyone equity awards or a worker cooperative, or selling to an existing ESOP company.
Can an ESOP Meet Your Goals?
1: Screening Questions
Is Your Company Big Enough?
ESOPs have tremendous advantages, but they are expensive to install and more complex than other retirement plans to maintain. You need to be able to absorb the initial costs (generally a minimum of $125,000) and have someone on the staff who can spend at least a few weeks’ time each year dealing with ESOP issues. A good rule of thumb is that you need at least 15-20 employees to consider an ESOP.
Keep in mind that however you sell your company, it will be very costly. Most sales to other buyers will be more expensive and have more contingencies than selling to an ESOP. See our article Are ESOPs More Complex and Costly than Other Ways to Sell Your Business for details.
Is Your Company Profitable Enough?
The money that will pay for the acquisition of your shares is an added cost. If you do not have enough profit to pay for that and operate your business, an ESOP will not work.
Is Getting the Highest Price Your Top Priority?
In perhaps 15% to 25% of the cases, you may be able to sell to another buyer for more than the ESOP can pay. That is because other buyers may perceive some synergies in combining your company with their operation (albeit this may mean that some of your people are laid off). Selling to an ESOP does not create those synergies, and the ESOP cannot legally match that price. In many cases, you can defer taxation when selling to an ESOP by reinvesting in stocks and bonds of U.S. operating companies, so net of taxation, you still might come out ahead, but not always.
Do You Need or Want All the Money Up Front?
If you are selling just part of the company now and maybe more later, an ESOP can usually obtain bank financing and get you the sale price up front. But if you want to sell most or all of the company, you will need to finance at least part of the sale with a seller note. That means you will be paid off over time, usually five to seven years, with a reasonable rate of interest. If that does not work for you, an ESOP may not work for you.
Are the Rules of ESOPs Acceptable?
ESOPs require that at least all your full-time employees who have worked for a year are in the plan and get allocations of stock based on their relative pay or a more level formula. You can’t pick and choose. Some owners only want certain employees to be owners. While you can give select employees additional equity awards outside the ESOP, you cannot limit ownership just to them.
Do You Have Successor Management?
Some companies are heavily dependent on their owner(s). When they leave, a lot of the business leaves with them. Other companies do not have qualified people to take over as leaders. An ESOP will not work without a good succession plan.
Does Legacy Matter to You?
One of the best things about ESOPs—and the primary reason most owners tell us they choose an ESOP—is that it preserves the legacy and values they have worked so hard to create. Selling to someone else would not. Part of that legacy is that you reward the people who helped you build it, whereas selling to another buyer may not always be a good result for these same people.
Do You Want to Stay Involved in the Company?
Another advantage of ESOPs is that you can sell all or part of the company and stay involved (or not) however you like. Lots of people end up doing that, whether staying on as CEO or moving to focus on some aspect of the work they enjoy.
Do You Just Want to Sell Part of the Company?
If you want to sell just part of the company, an ESOP makes that very practical. Selling just part of a company any other way is either impractical (outside buyers want the whole company) or very costly (because the buyers, often employees, have to pay after-tax dollars).
Run the Numbers: The ESOP Tax Advantage Calculator
In order to get a better sense of how ready you and your company are for an ESOP, we encourage you use our ESOP Tax Advantage Calculator. This will give you a better sense of both the readiness of your business for an ESOP exit strategy, as well as the potential benefits of selling your business using the ESOP model. If you're not ready to use the calculator, don't fret. The remainder of this toolkit will give you more information and you can revisit the calculator whenever you're ready.
Advanced: Try The ESOP Pre-Feasibility Calculator
If you've checked out the Tax Advantage Calculator and are ready to do a deeper dive, or if you're a professional advisor looking to guide clients through modeling a potential ESOP, try the powerful Excel-based ESOP Pre-Feasibility Calculator.
If you are not at the point of being ready to answer these questions, you may want to take a step back and start by reading Who Should Own Your Business After You.
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Excerpts from An Introduction to ESOPs
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2: Strategic Advantages
Nearly 6,000 privately held companies currently have employee stock ownership plans (ESOPs). Congress created the legal framework to encourage ESOPs in 1974 and intended ESOP law to give business owners another alternative when choosing who would own their businesses after them. Congress worked on the assumption that ESOP-owned companies would have advantages in performance and stability, later verified by extensive research.
ESOP companies take advantage of the power of employee ownership in many ways, from strategic planning to generating innovative ideas, from recruitment to retention.
For many business owners, ESOPs offer the advantage of putting their legacy in the hands of their co-workers instead of an outsider who may not value the history and character of the business.
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Research Highlights on Company Performance
ESOP Company Acquisition Strategies
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3: Employee Benefit
Congress created ESOPs not just as a way to own a business, but also as a way to provide an employee benefit. Legally, ESOPs are company benefit plans governed by many of the same rules as 401(k) plans. Many of the requirements for ESOPs on plan design, eligibility, company contributions, and distribution are intended to ensure that they are managed properly and fairly for all participants. By law, ESOPs must be broadly inclusive and allocate benefits to employees on a more level basis than typical 401(k) plans or equity compensation plans. Companies with ESOPs tend to have additional retirement plans, usually 401(k) plans, and on average they make larger contributions to employee accounts than non-ESOP companies do. Based on multiple studies and many decades of data, we know that ESOPs make a dramatic difference in the economic well-being of employees.
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What Happens in an ESOP Transaction?
If you are comfortable with the potential benefits and constraints of ESOPs, the next step is to understand what happens in an ESOP transaction and who can and must be involved. In short, the company and its advisors will design a transaction by determining key parameters, such as the portion of shares the ESOP will purchase and where the funds for that purchase will come from. The company will establish the ESOP trust and appoint a trustee, who will hire an appraisal firm to determine the stock’s fair market value. The current owner and the trustee negotiate the terms, close the deal, and the company begins its new era of employee ownership.
4: Valuation
All business sales require a valuation to determine what the eventual purchase price will be. To simplify it, the selling owner will claim the business is for sale for a specific dollar amount, the buyer will counter, and they will come to what they agree to be a fair price for both or they will walk away.
An ESOP, however, requires a third-party valuation in order to establish “fair market value” for the business in question. Since an ESOP is essentially the business selling internally, the presence of a third-party valuation assures the impartiality of the price for both seller and ESOP trust, which generally pays the equivalent of a financial buyer.
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5: Transaction Structures and Financing
Just like traditional M&A, transactions range from extremely simple to complex financial engineering. In the simplest transaction, a non-leveraged ESOP, the company contributes cash annually to the trust on a discretionary basis as profits allow. The trust uses these contributions to gradually buy shares. In another type of non-leveraged transaction, the company simply contributes shares to the trust.
More often, however, an ESOP transaction is financed at least in part by a loan: a leveraged ESOP. The loan can be from the seller, from one or more outside lenders on standard commercial terms, or a combination of the two. The borrowed money allows the ESOP to buy shares. The original owners can sell some or all of their shares. The company makes annual contributions to cover the repayment of the loan.
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Red Flags in ESOP Transactions
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6: Corporate Governance
A common misconception of ESOPs is that they literally involve handing over operational control to all employees in the plans. While successful ESOPs often increase the amount of input employees give and control they have over their day to day responsibilities, there’s nothing requiring them to do so.
Though ESOP companies remain traditional businesses in all but structure, the ESOP does require special considerations where corporate governance is concerned. The ESOP trust ends up as part of a trifecta with the company management and the board of directors, wherein the trust elects the board, which oversees both the hiring and compensation of the company executive as well as the trustee for the ESOP. As such, the board of directors can take on increased importance in an ESOP. The Board Excellence Toolkit provides a comprehensive collection of resources for best practices in corporate governance.
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Corporate Governance Practices in ESOP Companies
Who Does What in an ESOP Company
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Where the Roads Meet: Interplay between Trustee and the Board of Directors
7: ERISA and ESOP Fiduciary Matters
The law that formally established ESOPs as both a business structure and retirement plan is the Employee Retirement Income Security Act, or ERISA—the same law that governs 401(k) plans. As regulated retirement plans, ESOPs are subject to occasional scrutiny from the Department of Labor. This makes being an ESOP fiduciary—that is, anybody who makes a decision or causes a decision to be made for the plan—a role that requires expertise, care, and high-quality outside advice.
Sample Documents
ESOP Trustee Checklist for a Company Setting Up an ESOP
ESOP Fiduciary/Administrative Committee Workbook
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8: Communications and Culture
ESOP companies are known for high engagement, ideas-driven workplace cultures and are frequently cited as among the best places to work in their industry, location, or in general. These successes do not happen overnight as a result of the ESOP. They are the result of an intentional effort to create a company where employees think and act like owners.
Though this isn’t a requirement for an ESOP, the most successful ESOPs work very hard on developing their ownership culture. In fact, key studies on corporate performance have found that culture is critical to fully realizing the benefits of employee ownership. There are a variety of ways in which to do this—making feedback systems more responsive, using open-book management, creating a communications and culture committee—and not all ways will work for all companies. The first step is to assess the health of your company culture and what steps would need to be taken to create a company of owners.
Read
Looking to Jump Start Open Book Management? Quick Takes on Sharing the Numbers
Sample Document
ESOP Communications Committee Charter
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Integrating your EO Committee into a Broader Ownership Culture Strategy
Where Do I Go from Here?
9: Next Steps
This toolkit is the first step of many on the path to an ESOP transition—by now, many of your initial questions should have been answered, but many new questions will have taken their place. If you have decided that an ESOP may be the right option for you, your next step is to explore ESOP feasibility. Many sellers commission a full feasibility study, which will analyze your business’s situation and layout your options for transaction structure, financing options, cash flow, and other factors affecting your sale. Visit our Service Provider Directory to locate an ESOP practitioner that suits your needs.
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Choosing Employee Ownership Consultants
Innovative ESOP Transaction Structures (if you are interested in learning more about the variety of ESOP transactions)