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Pros and Cons of ESOPs

Pros and Cons of ESOPs

Employee Stock Ownership Plans (ESOPs) have expanded greatly since they were formally established in 1974. Today, there are nearly 7,000 ESOPs in the United States, with approximately 28 million employees participating. Is it a good option for your company? There’s lots to consider and many reasons to choose an ESOP.

For employees and management alike, ESOP participation can be a reward for dedication and hard work, as well as an incentive for future business growth. Explore the pros and cons of an ESOP.

What are the pros of an ESOP?

ESOPs are a long-term benefit for employees. Like a good healthcare plan or competitive paid time off, ESOPs can be an enticing aspect of an employee benefit package and help attract top talent to the company. ESOPs can help team members build significant wealth as shares appreciate over time.

ESOPs foster an ownership mentality, a teamwork perspective and employee retention.
ESOPs can be fantastic for employee morale, with everyone sharing interest in the organization’s success. When team members think strategically and strive to do their jobs with excellence, it’s a win-win for their careers and the company.

ESOPs offer serious tax and investment benefits. Since ESOPs are tax-exempt trusts, profits earned by the company stay with the employees — and that’s only the beginning. An S-corporation that is 100% employee-owned doesn’t pay taxes, which instantly translates to higher profit. You should consult your tax advisor for guidance.

Compared to an external sale, ESOPs can take less time to implement. An external, third-party sale can be a lengthy process, with many moving parts. So for owners looking to transition out of the company in short order, an ESOP can be an appealing option.

ESOPs allow for both instant and gradual ownership transition. With an ESOP, the current business owner can decide if it’s right to sell all ownership at once or instead remain a partner and shift gradually over time. Plus, using an ESOP to create liquidity for a minority stake won’t preclude an owner from selling to a third party later on.

What are the cons of an ESOP?

Current shareholders may not maximize proceeds from a sale to an ESOP. An ESOP is a financial buyer, not a strategic buyer, and so it can only pay fair market value to the current owner. A competitor, in contrast, may pay a premium to acquire the company and the current ownership can receive top dollar.

Companies require strong management to succeed during an ESOP transition. Especially if the current owner also founded the company, there’s plenty at stake when he or she transitions out of corporate leadership. Changing ownership structure calls for strong leadership to be in place.

ESOPs require ongoing administration and experience. From annual valuation and plan administration to legal and possibly trustee fees, ESOPs have multiple expenses associated with them.

ESOPs are not ideal for startups or very small businesses. ESOPs can only be used in C- or S-corporations, not partnerships or most professional corporations. The cash flow dedicated to the ESOP can limit what’s available to reinvest in daily operations, posing a challenge for earlier-stage companies. And shares must be repurchased when an employee departs, a small business could face a steep future expense if several team members leave at once.

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