An ESOP tale: An exit strategy for biz owners?

Nobody knows a business better than its employees.

Business owners who are beginning to make their plans for retirement increasingly look to their employees to provide the next generation of ownership. After all, who is more likely to understand the company’s business model, its customers and its industry than the current employees? And when that knowledge is combined with a substantial personal financial stake in the business, is anyone more likely to operate a company successfully for years to come?

If it’s structured properly, employee ownership can benefit both owners and employees. Generally known as an Employee Stock Ownership Plan (ESOP, for short), the ownership model is becoming more widespread. The ESOP Association, a nationwide organization, estimates there are approximately 10,000 ESOPs in place in the United States. They cover an estimated 10.3 million employees. About 4,000 of those companies are 100 percent owned by their ESOPs.

If an ESOP is done right, business owners have ready and willing buyers who will be invested in the long-term growth and health of the company. Many business owners also can receive significant tax benefits from the conversion of their business to an employee-ownership model.

Employees, meanwhile, receive an ownership stake that allows them to share directly in the success of the company. In most cases, they aren’t required to pay cash for the ownership position. They generally earn stock as an incentive, a bonus or part of their package of benefits.

Employee ownership does not make sense in all cases. Federal law doesn’t allow use of ESOPs in partnerships or most professional corporations. The costs of setting up even the simplest plan for a small business can run $40,000 or more. And because private companies are required to buy the shares of an employee who leaves the company, they sometimes can take a hard hit in ESOP expenses.

The National Center for Employee Ownership notes, too, that ESOPs have been shown to improve corporate performance only if they are combined with other opportunities for employees to participate in decisions affecting their work.

Because creation of an ESOP raises accounting, financial and legal questions that often become complex, good professional advice is important from the start.

But mature and successful companies that are valued correctly and well managed often become good candidates for employee ownership.

A 2014 survey found that 85 percent of the companies that have launched an ESOP consider it to have been a good idea. And about two-thirds of the companies that participated in the Annual Economic Performance Survey of ESOP companies reported that both their revenues and profits have increased since they introduced employee stock ownership.

Employee ownership can foster a superior corporate culture. Employee-owned businesses have the capacity to be more nimble and flexible, and employee-owned businesses often have longer tenured staff and highly committed employees.

A 2010 survey by Employee Ownership Foundation found, for instance, that only 13 percent of workers with employee stock ownership were planning to leave their companies within the next few months. That compares with 24 percent of the workers who didn’t own stock — a significant difference in potential turnover.

This corporate culture created by an ESOP can differ starkly from the climate in a company whose retiring owner decides to sell out to a large corporate competitor. Those buyouts may result in widespread layoffs and the reduction or elimination of departments such as marketing or human relations that duplicate those at the headquarters office of the corporate buyer.

That can be heartbreaking for business owners who want to see the companies they built continue to thrive as independent organizations led by dedicated veteran employees after the owners retire. An ESOP allows the company to remain independent and allows its profits to be shared among the employees who make it strong.

For the owner who sets up an ESOP, significant tax advantages often are available. Contributions of stock to the ESOP often are tax-deductible. So are contributions of cash in many instances. Again, good counsel is imperative to ensure that the ESOP is structured properly within the tax code.

Despite the many advantages of an ESOP, employees need to be careful that they don’t rely on their shares in the company as the sole basis for their retirement planning. Other retirement plans such as a 401(k) spread the financial risk across numerous companies and business sectors so that employees aren’t keeping all of their retirement eggs in one basket.

And despite the many advantages for business owners, ESOPs aren’t a good alternative for the Baby Boomer business owner who wants to cut all ties with the company and head off to beachfront property in Mexico six months from now. An effective ESOP requires a deliberative and structured approach to transitioning the company to its next generation of owners, and that takes time.

But for the right company with the right advisors, an ESOP is a powerful tool for the owners and employees alike.

John Solari is the managing partner of J.A. Solari & Partners, a corporate accounting firm based in Reno.