How To Set Up An ESOP Plan

An Employee Stock Ownership Plan, otherwise referred to as an ESOP, refers to a type of employee benefit plan that gives employees ownership interest in the company. In other words, an ESOP is a strategy that enables workers to purchase a number of shares in a company, essentially becoming owners of the company they work for.

Before we dive into the steps involved in how to set up an ESOP plan, let’s look at why this is becoming more popular, and what this kind of strategy could mean for companies, employees, and business owners.

A Graceful, Alternative Exit Strategy

As a business owner, you’re keenly aware of the fact that there’s an end goal in mind for you and your business. There are various ways to handle your exit, including the traditional method of passing the family business down or investigating the mergers and acquisition route. 

Neither of these options is as common nowadays, leaving many owners wondering what to do when the time comes to leave their companies – particularly if their net worth is tied up in the business itself. 

An alternative option is to figure out how to set up an ESOP plan. This option allows you to sell stock to employees instead of a third party, giving you peace of mind that your company will be in the hands of your trusted management team. It also means that your information will remain private and not shared with prospective buyers. 

The 7 Benefits Of An ESOP

Sure, you could use an employee stock ownership plan in the traditional sense… as a means of remunerating senior employees to acknowledge their contributions to the company. 

But why stop there? If you talk to start-ups and small-to-medium sized businesses about why and how to set up an ESOP plan from their perspectives, you’ll quickly learn that there are serious advantages behind this type of succession plan. 

Here the 7 advantages that ESOPs bring to the table:

1. Increased productivity

With a share of the company in their pockets, employees feel a sense of ownership and because they will directly benefit from the success of the company, there is often an overall performance improvement, higher levels of motivation, and an increase in productivity.

2. Tax advantages 

ESOP structures allow for multiple tax advantages. For example, C-corporations will find that contributions made to ESOPs are tax-deductible. For S-corporations, however, the portion owned by the ESOP is tax-exempt. Additional tax advantages include the fact that stock contributions are tax-deductible, as are contributions used to repay the ESOP loans. Finally, employees aren’t taxed on the contributions received. In fact, individual employees only have to pay tax on the ESOP when they ultimately withdraw the money after retiring.

Knowing how to set up an ESOP plan so that you can get these tax advantages can be challenging, which is why it’s often best to consult experts, like Excel Legacy Group, who can guide you through your options.

3. No change in governance 

An ESOP is one of the few succession plans that allows the business owner to step back and not have to worry about the typical disruptions that are caused by a change in leadership. These kinds of disruptions often jeopardise relationships with long-term suppliers, distributors, and customers and can potentially threaten the survival of the business. 

Through an ESOP you not only avoid these kinds of disruptions, but the consistency of employee ownership can greatly improve employee loyalty to the company.  

4. Attract the best 

The opportunity to have a share in a company can be an extremely attractive bonus for top talent seeking new job opportunities. Not only because it gives employees a sense of ownership, but because it also provides a secure retirement plan.

5. Keep the best

Part of how you set up an ESOP includes determining the vesting process. For example, employees who stay less than two years at a company could have a much lesser percentage of vesting than someone who vested over the determined 100% vesting period. 

An example would be if the vesting period is five years, then each year you continue to work for the company would garner you 20% vesting until you reach the fifth year. In the fifth year, you would be 100% vested in the ESOP retirement fund and entitled to receive your share payout. 

This serves as a strong motivator for employees to stay with their company and give of their best in order to earn the highest payout if and when they decide to leave. 

6. Stay in control 

An employee stock ownership plan gives you the advantage of staying involved with the company business for a period of time of your choosing. If it’s not in the best interests of your business to bow out immediately, then you don’t have to. 

7. Exit with peace 

Because you are passing your business onto those valued employees who helped you build it, you have the rarified opportunity to exit with peace of mind, knowing that those who are integral to the business’ survival will be even more invested in its continued success. 

How To Set Up an ESOP Plan

Step 1: Seek expert advice

Even though the idea of an ESOP may seem straightforward, there are dozens of variations, requirements, and legalities that must be navigated. Advice from experts will save a lot of time, cost less, and ultimately help you end up with the right structure. 

Step 2: Find out if all the owners are willing to sell

You may go to a lot of trouble along the journey of how to set up an ESOP plan only to find out that the parent company is unwilling to sell or that there are other owners of the company who will never agree to an ESOP. This could cause a good deal of trouble further down the road.

Step 3: Check the minimum requirements

There are minimum requirements to qualify for an ESOP, such as if your company is a corporation (S or C), if it has greater than $1 million in revenue in TTM of EBITDA, or if there are more than 15 employees.

Step 4: Understand the ESOP structures

There are various types of ESOP structures, including leveraged ESOPs, non-leveraged ESOPs, convertible preferred stock with a put option, and convertible preferred stock with guaranteed redemption.

Step 5: Compare change of ownership alternatives

There’s a degree of flexibility in the ESOP structures available, which ideally, means that you should find the right option to satisfy your specific company owner initiatives compared with other change of ownership options.

Step 6: Conduct a high-level valuation 

A vital step in how to set up an ESOP plan is the valuation. After collecting the necessary information it’s possible to move onto having a valuation done to verify if the range of values produced is acceptable. This includes reviewing factors like cash flow, profits, market conditions, assets, comparable company values, and overall economic conditions. The outcome will determine whether the value is too low or if the price of the shares is too high.

Step 7: Conduct a feasibility study

A comprehensive feasibility study is generally only needed when it’s uncertain whether the ESOP will be able to repay the loan. To that end, an analysis will review how much extra cash flow the company has available to devote to the ESOP, whether this cash flow is sufficient, if the company has adequate payroll for ESOP participants to make the ESOP contributions deductible, and estimates of what the repurchase obligation will be and how the company will handle it.

Step 8: Time to finance 

When it comes to finance, there are multiple options, including ongoing company contributions, existing benefit plans, the option for employees to contribute to the plan, and bank loans. From there on, it’s a matter of drafting and submitting your plan to the IRS. The complexity around this, particularly from a tax standpoint, can be extremely technical. At Excel Legacy we combine the expertise of financial, investment banking, tax and legal professionals to assist companies in the structuring and funding of your ESOP. 

Step 9: It’s execution time

The deployment of an ESOP necessitates a trustee to oversee the plan. This individual can be from inside or outside the company and is generally directed by an ESOP committee. This committee is usually comprised of management people. That said, many ESOPs allow for some non-management representation. 

Step 10: Communication

Finally, how the ESOP will work must be communicated with employees. In fact, the ultimate success of your ESOP can depend on how well the benefits of the plan are communicated to the employees. There are several studies showing that those companies who invested in informing employees of their importance and influence on corporate profits, and how those profits related to the increasing price of their shares, saw a measurable improvement in productivity, turnover, absenteeism and efficiency. 

We Can Help 

This type of employee plan offers many benefits for business owners looking to plan for the future and Excel Legacy Group is passionate about educating and assisting those who want to know more about how to set up an ESOP plan. 

Let our ESOP experts guide you through a process to determine if this is the right move for you and your business and make sure that you comply with all the legalities and criteria that need to be observed in the process.

Talk to us today.