How Small Is Too Small for an ESOP?, Raising Capital Article

One question frequently asked by company leaders on the topic of employee ownership is Are we too small to have an employee stock ownership plan?

There is no simple answer to this question, and certainly there are no upper or lower limits per se on the size of a company sponsoring an employee stock ownership plan (ESOP). There are, however, some basic guidelines that can help you determine if an ESOP is worthwhile.

Calculating the Cost

First, of course, you need to know how much an ESOP will cost. Unfortunately, cost estimates vary widely from one case to another and one consultant to another. There are several components of cost: preparing plan documents and government filings; obtaining a valuation; administration; and, in a leveraged ESOP, loan commitment fees, legal fees for the lender's counsel and loan documents, and, possibly, financial consulting for structuring the transaction.

The cost of drawing up the plan documents and government filings is generally not as much as people think it will be. In a small company transaction, lawyers tell us fees of $5,000 to $10,000 would be typical. These costs will be somewhat lower if you come well prepared, already understanding the basics of ESOP rules and knowing what you want your plan to do. Most ESOP attorneys have plan documents on word processors. Their fees are more a function of the time they spend with you figuring out what the document should include.

Valuation normally will carry fees in the same rangefor smaller companies, assuming that there is only oneclass of stock in the company and no unusual complicatingelements. Repeat annual valuations should be about halfthis fee. It may be possible to obtain an even lower chargein some cases, but it is imperative that costs not be cut byhiring people who do not normally do ESOP work.

Plan administration costs -- keeping records, filingreports, sending plan account statements, etc. -- depend onthe number of employees. There are certain fixed costs,however, so there are some economies of scale for largerfirms. A firm of 20 employees might reasonably expect topay around $2,000 per year.

Where costs become really high is when an ESOP borrows money. The lender usually wants legal opinions from its counsel, charges loan commitment fees, and needs loan documents prepared, not unlike the fees involved in amortgage transaction. Even in a transaction of severalhundred thousand dollars, this could add another $10,000to the costs. If a loan cannot be easily obtained or if thetransaction involves multiple sources of financing, it maybe necessary to hire a financial adviser to help structurethe deal. These experts often charge a percentage of thetransaction costs, typically 1% to 3%, with the percentagea function of the size of the transaction.

All of these estimates should be viewed cautiously. Invariably, when we report costs, we receive at least a few calls from people who say we misled people. Some say our estimates are much too high; some say much too low. The truth is that costs vary considerably depending on the nature of the transaction. The costs listed here are"ballpark" numbers for simple transactions.

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Assessing Costs vs. Benefits

There are several things to consider when trying to figure out if these costs can be justified:

What are the alternatives? It may well cost $25,000 or more for a leveraged ESOP to buy out part or all of an owner's interest. That may seem exorbitant in, say, a $500,000 sale. But what are the choices? If the company is sold by a business broker, a percentage of the fee will be charged that will at least match that. If a partial interest is for sale, it may be difficult or impossible to find another buyer willing to offer a reasonable price, adequate security, or a satisfactory continuing employment relationship if the seller wants to stay with the company. Employers may also strongly prefer to have employees own the company.
What is our tax bracket? If you are not payingtaxes or are in a low tax bracket, some tax advantages may have little application, although the rollover benefits may still be worthwhile to the seller.
How will annual costs compare to annual contributions? The annual fees you pay, includingan amortized amount for start-up costs, should be less than the amount of annual contributions you make multiplied by your tax rate. (If your costs are $9,000 per year, and your combined federal-state tax rate is 30%, you should be able to contribute at least $30,000 a year.) Otherwise, you might consider a non-tax qualified plan.
Is our payroll adequate? Figure out what theeligible payroll of the people actually in your plan will be (exclude pay of people who will not qualify for participation or an individual's pay over $150,000 a year). Then multiply by 25%. In a leveraged plan, multiply this number times the number of years of the loan, and this will give you an estimate of the maximum amount you can borrow. Is this going to be enough of an annual contribution tobuy as much stock as you want to make available? As a rule of thumb, ESOPs work best for companies with more than 20 employees, but a little back-of-the-envelope calculating can give you a much better idea.