How To Decide If Your Company Needs An Esop
An Employee Stock Ownership Plan carries three fundamental benefits and three fundamental disadvantages for a closely held company.
Briefly, the benefits are:
* It enhances cash flow by providing a generous tax write-off at no initial cash outlay. Or, if the company already has a pension, profit-sharing, or similar retirement plan, and is taking the maximum tax deduction for it, then replacing it with an ESOP can recapture money -- now flowing to a bank trust department -- to use to finance the company's growth. An ESOP also currently qualifies for an additional tax credit, while other plans don't.
* An ESOP can be a significant way to boost employee productivity and morale. Workers acquire their own stake in the company; if the company prospers and its stock appreciates in value, they reap handsome capital gains.
* An ESOP can serve as an inhouse market for a private corporation's stock, allowing current owners to sell off part of their interest in the company with favorable tax treatment -- and still maintain control, even if the ESOP eventually becomes the largest shareholder.
The disadvantages are:
* Eventually, shares contributed to the trust must be redeemed in cash. If the company is profitable and plans correctly, then the redemptions won't be a burden, and they'll even generate a tax deduction of their own. If they all bunch up in one year, they can strain cash flow and exceed the maximum allowed tax deduction.
* If the value of the company's shares falls, then employees share the loss, and morale may suffer.
* If the contribution is in the form of newly issued stock, then the ESOP dilutes the current stockholders' ownership. The fair market value of each existing share goes down immediately after new ones are issued, since the same total value must be divided among more shares. In order to compensate, the money saved through the first advantage must help the company raise its value in the future. Whether that happens depends on how successfully management uses the new funds.
How can you pinpoint whether the advantages outweigh the disadvantages for your company?
Ask yourself these questions:
* Is the company profitable? An ESOP can't rescue a failing firm. If the company's prospects are poor, then the appraiser may set a low value for its stock. tax deductions are based on the value of the shares contributed to the trust, so a low value could require the company to give up a hefty block of shares to get a worthwhile deduction. In other words, the present owners would bear too much immediate dilution.
* How much net worth does the company have now? If the company is young, with low net worth, then again, an appraiser will probably value its shares accordingly, entailing massive dilution to current stockholders.
* If the company has a pension or profit-sharing plan, how is it faring? Says lawyer John D. Menke: "Many company presidents tell me that their profit-sharing plan is having no effect on motivation or productivity -- their employees aren't even noticing it. Often employees are disgruntled with typical investment returns of 4% or 5% a year."
* Does the company need more capital? Many small companies can't borrow much more, either because they can't afford the interest, or because they're already too leveraged for their bankers' tastes. "For a small company, if you can borrow and can afford the cost, then you're probably better off doing that," rather than suffering the dilution of an ESOP, advises lawyer Jack Curtis.
* Who needs the performance incentive? According to ERISA rules, and ESOP can't be used to favor top management. Although ESOP benefits are usually based on salary, the differential between the top people and the rest of the employees may not be wide enough to pack the desired wallop for executives. Other ways to motivate top people are through IRS-qualified stock options or bonuses. These can also be combined with an ESOP, within IRS limits.
* Is the company in the full corporate tax bracket? If it already enjoys extensive tax credits or depreciation allowances that lower its bracket, then the tax benefits of an ESOP would be correspondingly less.
* Is management sympathetic to employee ownership? If not, "Even if an ESOP fully accomplishes its financing objectives, the company may end up with problems," says ESOP lawyer Ronald Ludwig. "In one company, three or four years after installing an ESOP, I heard management complaining: 'Some of the employees are going around talking as if they own the place."
* How much of the company are owners willing to see employees assume? A 5% to 10% stake isn't enough to motivate employees. "To ask if that works is like asking if your dental plan works," quips Corey Rosen, executive director of the National Center for Employee Ownership. The typical ESOP firm is 20% to 30% employee-owned after five years.
* Might the company go public in the foreseeable future? If the stock market is favorable, the company may get more for its shares that way than at the price an appraiser settles on. In the market, the company's stock may command a speculative premium; an appraiser must stick to known fact. Thus it would suffer less dilution for the same financial benefit as an ESOP.
* Does the principal shareholder need a market for his stock -- perhaps as an estate-planning tool? Upon the principal's death, an ESOP may be able to buy enough of his shares -- with the company's pretax dollars -- to cover estate taxes. And it could provide his heirs with a convenient buyer for the shares they inherit.
* How many shareholders does the company have now? Do they agree on the goals of the ESOP? Suppose two people currently hold all the stock in a 60%-40% ratio, and the majority owner wants to cash out shares by selling to the ESOP. He can't retain control unless the minority owner also sells shares. They need to agree in advance on a policy -- perhaps in writing.