Business succession planning options: ESOPs

Kristin Nelson
Posted by Kristin Nelson
Wealth Management Strategy

Family is often a major consideration when it comes to business succession planning. As a business owner, you might have a larger “extended family” in your company, and you may also be thinking of them when it comes to succession planning.

Employees meeting around a wooden table in sunny officeWith that in mind, one option a business owner might consider is an Employee Stock Ownership Plan (“ESOP”). This blog with explain what an ESOP is and the advantages and challenges of this succession alternative.

What is an ESOP?

Oftentimes people confuse an ESOP with a stock option plan, but an ESOP is very different and may provide unique advantages and benefits. Stock option plans typically allow employees to simply buy stock at a favorable price, while an ESOP is operated by a tax-exempt trust to enable employees to achieve ownership in the company without having to invest any of their own money.

Why an ESOP may be worth considering for your business

Many business owners have considerable capital tied up in their companies, and they often look for ways to improve the use of their capital while improving the performance of the business. An ESOP, may be exactly the right tool to achieve both objectives.

Reasons to adopt an ESOP

Companies create ESOPs for a variety of reasons, including:

  • to allow the business owner to diversify and access liquidity
  • to ensure business continuity after retirement
  • to broaden capital distribution
  • to build or enhance an employee retirement plan
  • to enhance employee motivation.

Research shows companies that offer an ESOP often outperform companies that don’t offer an ESOP. For example, ESOPs appear to increase sales, employment, and sales per employee by about 2.3% per year, according to research performed by Douglas Kruse and Joseph Blasi of Rutgers University. The study also shows that sales, employment and productivity all grow faster after setting up the ESOP than projections based on performance before the ESOP. While these differences seem small at first glance, projected over 10 years the differences amount to about a 30% difference in company size and profitability from similar starting points.

Companies that offer ESOPs along with other employee ownership plans consistently make up more than half the firms on Fortune Magazine’s “100 Best Companies to Work For” lists. Employee turnover is much lower in companies with ESOPs compared to companies without a plan, and employees who participate in an ESOP earn more than employees who are not covered by an ESOP, according to the National Center for Employee Ownership.

Possible advantages of an ESOP

Adopting an ESOP enables a business owner to exchange his or her equity for a more diversified portfolio without having to sell the entire business. In these cases, the ESOP buys the shares of an exiting or retiring owner. The owner then has the use of the funds without having to leave or lose control of the business. An ESOP can also provide a ready market for a closely held firm, and it may be one of the most tax-advantaged ways to sell ownership in the firm.¹

An ESOP may offer a powerful incentive for employees to increase the value of the company, as they are often more motivated and productive than employees without an ESOP. It may increase teamwork and, as stated above, improve overall company results. An ESOP can also serve as an additional source of retirement income for employees, allowing them to potentially amass greater wealth than they would have otherwise, even if they are covered by other retirement plans.

An ESOP is a complex and sophisticated tool, so you should consult with a professional advisor who can guide you through the necessary steps and ensure that an ESOP is the right solution for your business succession plan.

Possible challenges of an ESOP

A business owner needs to be mindful of how soon they want to exit the business. If the company doesn’t have the funds they will not be able to buy all of the owner’s shares. Also it is critical for the business owner to have successor management in place prior to their exit in order to keep the business running smoothly, which in turn will continue to give the business a positive valuation.

Regardless of what strategy you implement for your business succession plan, it’s important to take the time to understand the variety of options and choose the one best suited for your goals. Be sure to refer back to my post on “Making a plan for business succession.”

 

¹NOTE: Please consult with a tax professional to review and clarify any tax ramifications. Bank of the West does not give legal or tax advice.

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  • Anonymous says:

    I’d like to see more public corporations consider an ESOP when going private or divesting a portion of their business. Also, employees should take the initiative before their company ownership changes to use a leveraged ESOP to buy the company. The current owner and the employees can create a Win-Win opportunity when utilizing an ESOP as an exit strategy.

    Reply | 11 months ago

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