What is an ESOP (Employee Stock Ownership Program)?

You’ve built a successful business, but you’ve begun thinking about an eventual exit. You could sell or pass the business to a family member, but that could create uncertainty. For owners who want to preserve their legacy, and the jobs of their employees, an Employee Stock Ownership Plan (ESOP) could be the answer.

The owner may also receive capital gains tax benefits and interest income from financing a portion of the sale through seller notes. Employees, meanwhile, could realize a retirement benefit that may exceed most available plans.

These considerations could help determine whether an ESOP could be an attractive option for you and your business.

What is an ESOP, and what companies qualify?

An ESOP is a qualified retirement plan that gives employees the chance to receive interest in employer stock. Upon retirement, employees can either receive cash or shares, which are then sold back to the company.

To qualify for an ESOP, a company should be closely held, have EBITDA in excess of $3 million, have at least 30 employees, and have an annual payroll of $1 million or more.

Why would an owner consider an ESOP?

With an ESOP, the owner still runs and manages the business the same as before. The only change is that the shares are owned by a trust for the benefit of employees. Forming an ESOP can be a good way to help protect the jobs of employees, which may be lost in a sale. Additionally, any S corporation that is 100-percent ESOP-owned does not generally pay federal income tax.

The drawback is that they’re complicated to construct and require knowledgeable professionals to close. But once in place and acquisition debt is paid off, employees often tend to not only be more productive, but they are more careful with expenses because they are invested to improve the company’s performance for their own benefit. However, ESOPs are not for everyone. It’s math, not magic. It can work for a lot of companies, but owners need to spend time with their banker learning about ESOPs before deciding whether to move forward.

How can my banker help with forming an ESOP?

Your Huntington banker can help coordinate resources, such as a financial advisor, who will conduct a feasibility study and help the owner understand tax benefits and accounting changes. They will also coordinate with an ESOP lawyer, who will write an ESOP plan. The lawyer and financial advisor can also help the owner choose a trustee for the trust who will own the company’s stock and who will maintain fiduciary responsibility for the benefit of the employees.

What is the typical ESOP transaction process?

The trustee will hire an evaluation company to determine the full and fair price for the company’s stock. The owner and the trustee, with their respective financial advisors, will then negotiate and ultimately settle on a purchase price, which may be eligible for financing through your bank. The trust typically borrows money to buy a portion of the company’s stock, and then borrows the remainder from the owner to buy the rest.

The bank’s loan is the senior debt, under which the seller notes—the portion the owner provides—are subordinate. As the company generates money during the normal course of business, it pays down the senior debt to the bank. Then the company asks the bank to refinance a portion of the seller notes, pays off that loan, then repeats the cycle until the company pays off all of the seller notes.

Owners typically continue to work in the business until the seller notes are paid off, which generally takes about five years, but could be faster because employees tend to become more productive once they have a stake in the company. Via specific tax elections, the owner may be able to defer the capital gains of the sale. And the business, which is now fully owned by the ESOP and held in trust by the trustee, usually doesn’t pay any income tax, even though it continues generating profits.

Huntington has helped many businesses navigate this complex solution. To explore whether an Employee Stock Ownership Plan (ESOP) is right for your company, contact your relationship manager.