Despite appealing reasons for business owners to establish an employee stock ownership plan, or ESOP, an enormous knowledge gap exists that prevents many owners from even considering one.  Many view an ESOP as the last resort when contemplating an eventual retirement or succession plan, believing it too complicated.

If that’s your view, let me address the misperceptions. Having structured over 300 business family and private business transitions, I’ve found that an ESOP should absolutely be one of the alternatives weighed by business owners for two powerful reasons: ESOPs offer potentially compelling benefits at the time of sale. And, because they increase employee engagement, ESOPs can help improve a company’s performance.

ESOPs increase optionality for business owners

Increased optionality is the chief reason business owners should think about establishing an ESOP. At the time of sale, an ESOP gives an owner more than one solution to a complex situation. It also provides personal liquidity, wealth diversification and tax advantages.  Quite simply, an ESOP is a leveraged recapitalization that uses a business’ equity value to obtain debt financing. Further, the ESOP’s shareholder is exempt from federal income taxes. Let me note that again: Sale of an ESOP-owned company can be structured in such a way that the company, and not the shareholder(s), pay federal income taxes.

In view of these considerable benefits, what often gets in the way? Three persistent misconceptions diminish owners’ interest:

  1. The belief that owners lose operating control of their companies when they create an ESOP. Not true. The ESOP is a beneficial owner as well as a retirement plan trust, but ESOP members don’t sit on the board and don’t manage operations. As a trust, they certainly will observe management decisions and strategies to grow the value of their share, but they are not involved in day-to-day business oversight. Compare that to the hands-on involvement that sellers to private equity firms experience.
  2. The fallacy that an owner won’t get a fair market value by selling to an ESOP. While it is true that an ESOP cannot pay more than a business’ fair market value, the ESOP can pay every dollar of fair market value, determined through a market valuation exercise (versus an auction). Whatever the reason, private equity firms and investment advisors involved in the possible purchase of a business often don’t do much to dispel this misleading notion that owners won’t obtain fair market value through an ESOP sale.

We often address this concern by completing a dual-track process that conducts a traditional auction while simultaneously pursuing a sale to an ESOP.  In one instance, while the owner chose to sell to a private equity firm, the dual-track exercise helped the owner obtain materially better terms than were being offered without the ESOP alternative. These included an increase in the purchase price and a reduction of more than 50 percent in escrows, holdbacks and indemnifications.

  1. The impediment that ESOPs are viewed by some financial advisors – many of whom haven’t had equal amounts of experience handling ESOP transactions as they have sales to a private equity firm or strategic buyer – as just too complex. ESOPS, which are structured under U.S. law as an employee retirement plan, are more nuanced to construct. But the increased optionality and substantial tax benefits to the family at the time of sale, coupled with benefits from increased employee engagement, demand that an ESOP structure at least be considered as one of the exit alternatives.

ESOPs improve employee engagement, contributing to better business performance

Benefits of ESOPs aren’t limited to a potential exit. Growing research indicates that an ESOP benefits employees. Employees who participate in an ESOP tend to be more motivated to perform, earn more in wages by a double-digit figure than do employees at traditionally owned companies, possess retirement accounts 2.2 times larger, and stay longer and are less likely to be laid off during economic downturns.

Indeed, a University of Copenhagen researcher using a rarely used data source, the 1997 National Longitudinal survey of Youth, found recently that ESOP participation increased wages for U.S. workers by nearly 13 percent, much higher than previous estimates, and that male and female workers enjoyed near-equal economic gains.

What we counsel owners

We advise business owners to look for an advisor who puts an ESOP’s benefits in simple terms without getting enmeshed at the outset in the intricacies of the tax code. If an ESOP structure works, you can then hire an experienced team to make sure it benefits your employees and doesn’t raise flags with the Department of Labor.

Consider what Mandy Cabot did when she was set to sell her successful Dansko shoe firm. Dansko’s high-quality, closed-back clogs, long worn by medical staff, teachers and others who spend a lot of time on their feet, caught on in the expanding comfort footwear market. Timberland became interested and was a prospective buyer of the company. In addition to an attractive price, Timberland offered other advantages, including excellent R&D, international sales and a sophisticated financial plan. But Cabot was committed to the idea of employee ownership. Ultimately, she abandoned the Timberland deal and moved ahead with new projects. In 2012, she sold all of Dansko’s shares to an ESOP, in a deal we helped arrange.

Other owners decide, as National Van Lines Chairman and CEO Maureen Beal did, to embrace an ESOP instead of selling the family-owned business to another company. Under its ESOP plan, which we helped develop, this family’s moving business got an initial 25 percent down payment on the sale price with the remainder paid over a period ending when the ESOP assumed full control.

A new federal law – the Main Street Employee Ownership Act that went into effect last fall promises to help many owners of small and medium-sized businesses become more aware of ESOPs’ advantages. It makes better use of Small Business Administration programs through improved access to capital and technical assistance.

So, in short… When an owner is mulling retirement, an ESOP can prove an excellent alternative to being acquired by a private equity firm or a strategic buyer, after having increased employee engagement while he or she was operating the business. That’s not just an attractive option, it’s two benefits for the price of one!