ESOPs Advantageous For Employees and Employers
When Mic Mead, founder of Adventure 16, a Southern California outdoor and travel-product company, decided to sell his business, he didn’t want to leave it to just anyone. He wanted his employees to benefit more from the sale than Uncle Sam did.
And they’ve been doing just that since Mead sold Adventure 16 to them through an employee stock ownership plan in April 1995.
An ESOP is a type of profit-sharing plan. In an ESOP, a company sets up a trust fund that invests primarily in the stock of the employer on behalf of employees.
Each employee participating in the ESOP has an account that receives a portion of the trust's shares, which gradually becomes vested. Employees don't cash in their shares until they retire or leave the company. Often, the prior owners can, as a practical matter, maintain operating control of the company.
Although ESOPs have been around since the late 1960s, their various uses and advantages are still not completely understood. The most common and powerful use of an ESOP is to borrow money either to buy the stock of a retiring owner in a closely held company or to expand the company.
Here is how it works: The ESOP borrows cash from a bank to buy the retiring owner's shares or to issue new shares. The company then makes contributions to the ESOP out of cash flow, enabling the ESOP to pay off the loan.
Since contributions to ESOPs can be deducted from the company's taxable income, both the loan's principal and interest become tax-deductible for the company.
Purchasing a departing owner's shares through an ESOP is not just a smart way to put the company in the hands of people with an interest in its success. It's also the most tax-effective way for the owner to sell his shares.
If the ESOP owns at least 30 percent of the stock and the owner invests the proceeds from the sale to the ESOP in the securities of other U.S. operating companies, he can defer the capital gains tax on the cash received in the buyout.
In addition to providing tax benefits, ESOPs can motivate employees. Research shows that giving workers a significant stake in their companies increases their dedication, improves their work effort, and reduces absenteeism and turnover.
Last year, the law firm of Reish & Luftman surveyed over 600 companies with ESOPs. Of companies that responded, 93 percent reported reduced absenteeism among employees, 86 percent indicated a drop in turnover, and 79 percent noted an increase in morale.
Indeed, ESOPs have been well received by both management and employees: Nearly 75 percent of respondents said their ESOP met both company and employee expectations. Where the respondents said the ESOP affected the company's growth, almost 90 percent indicated that the change was positive.
Although ESOPs can be found at large corporations such as United Airlines and Avis Car Rental, ESOPs are primarily established in small closely held businesses. About 10,000 companies nationwide have ESOPs, with about 10 percent of the U.S. workforce as participants.
So, you ask, what kinds of companies make good candidates for an ESOP?
As a rule of thumb, ESOPs work best for companies with over 20 employees. Since tax deductions are useless without taxable income, a company should be profitable enough to make the costs of the plan worthwhile. Legal, accounting and consulting fees to set up an ESOP can range from $15,000 to $25,000, and administration costs can run an additional $2,500 to $5,000 the first year and each year thereafter.
A company must determine whether ESOP costs will be less than the yearly savings on taxes, and whether an ESOP will actually be less expensive than other ways of either setting up a benefit plan, buying out a departing owner or motivating employees. Privately held companies with ESOPs must be prepared to meet their obligation to buy back stock from employees who leave.
More important, an ESOP will most improve corporate performance if the ESOP is combined with opportunities for employees to participate in decisions affecting their work. To that end, management must be genuinely committed to treating employees like owners.
Furthermore, the potential improvements in employee productivity that an ESOP encourages can be best realized if the company communicates effectively with its employees about the advantages an ESOP offers them. Employees won't understand that they own a piece of the company and that their performance affects their own stock holdings unless the company implements a good communications program.
There is a wide range of options for tailoring a plan that is best suited to a company's particular goals.
Once the purpose of establishing an ESOP is determined, such as financing expansion, enhancing employee motivation or creating an employee retirement plan, a company should determine the feasibility of the plan and design its specifics before implementing it.
Setting up a plan takes effort, but the results can be well worth it. Just ask Mic Mead.
© 1997
of the Los Angeles Business Journal.
Learn more about R&R related practice areas:
Business
Employee Benefits
ESOP
