Understanding an Employee Stock Ownership Plan

workers teamAn Employee Stock Ownership Plan (ESOP) is a tax qualified retirement plan that is structured to invest in qualifying employer securities (primarily employer stock). It is estimated that there are approximately 10,000 ESOPs in place in the U.S., covering 10.3 million employees and representing approximately $869 billion in total assets.

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An ESOP can be an attractive liquidity option to a traditional M&A process when market conditions and limited strategic buyers create difficulty obtaining a premium valuation. ESOPs provide many advantages to the Company, its shareholders, and employees, and have risen in popularity in recent years. These advantages differ depending on whether the company is an S-Corp or a C-Corp.

Selling Shareholders:

1. Selling shareholder can avoid paying capital gains taxes on proceeds from a sale through a 1042 rollover and invest proceeds in Qualified Replacement Property (QRP).

2. QRP can be monetized so selling shareholders still own it but can convert it into cash to spend however they wish.

The Company:

1. Companies owned by an ESOP may be exempt from state and federal income tax if the company is an S-Corp and 100 percent owned by the ESOP.

2. There is significantly enhanced free cash flow available to pay down debt.

3. Contributions to the ESOP are tax deductible.

4. Company may deduct dividends paid on ESOP stock which is used to repay the ESOP loan.

The Employees:

1. Management employees typically have limited resources and have difficulty obtaining the financing required to purchase the Company; an ESOP provides them with alternatives as existing funds in 401k accounts can be used to invest in Company stock, reducing the amount of financing needed to complete a transaction.

2. Employees are allocated stock on an annual basis as a portion of their overall compensation; this stock vests over time as the loan is paid down.

An ESOP is a complicated transaction and requires specialized analysis to understand whether such a transaction is advantageous to company owners versus a traditional sale or recapitalization.

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Alan Bugler

Alan Bugler
Alan Bugler is a vice president at Childs Advisory Partners. He can be reached at abugler (at) childsap (dot) com.

Alan Bugler

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