Employee Stock Ownership Plans, or ESOPs, are benefit plans that give the employees of a company ownership stock in the business.
For some business owners, and for some businesses, it can be a great option. However, there certainly are disadvantages of ESOPs and we’ll highlight some potential pitfalls that small business owners may run into if they choose the ESOP route.
Don’t get us wrong, we love ESOPs. Their result can be excellent for employee morale and retention and the tax benefits can be astounding! However, for many lower middle-market companies, there are often much better options for selling your business. Unless your company is in the bracket of 40+ employees, has a strong management team, and produces relatively consistent financial results, we would advise you to proceed with caution as the disadvantages of ESOPs may outweigh the advantages.
Potential Disadvantages of ESOPs
Low Business Valuation
Generally speaking, an ESOP isn’t going to get you, as the seller, the highest price on the business. When utilizing an ESOP as an exit strategy, the price that an ESOP can offer per share is limited to the fair market value of those shares. This price is generally lower than the company would fetch with a strategic, private equity, or family office buyer, especially if they are competing for your business.
It depends on your top priority – achieving as close a guarantee as possible in regards to continuity of the location, culture, and employee base; or maximizing the valuation of the business through a competitive sale process. If the latter, a better plan is to find a third-party buyer to purchase the company in its entirety. Also, it is important to note that the goals of local business continuity and price maximization are not mutually exclusive. We facilitate sales all the time where the price and deal structure are maximized for the owner and the buyer is a great cultural fit for the long-term continuity of the business.
A Longer Transition Out
Once again, it’s important for you as the seller of the business to examine your own objectives as this could be a pro or a con. If you’re wanting to transition out of the business in a timely manner, so that you can retire, unburden yourself from the demands of running the company, or pivot into a new career path, an Employee Stock Ownership Plan is likely going to keep you locked down for a while yet. It’s typical for a business owner to stay on for a transition period as the company is transitioned to a new leadership team (and often members of this team need to be located!). If you’re considering ESOP, it is a best practice to start identifying your internal rising stars many years in advance of your desired exit.
A Heavy Financial Burden on The Company
Depending upon the size of your business, an ESOP may not be a cost-effective option. A clear disadvantage of ESOPs is that they can cost upwards of $100,000 to set up, and the initial cost may end up outweighing any eventual tax benefits. ESOPs are expensive to set up, and expensive to maintain as an appraisal is required annually to stay in compliance. If the cash flow dedicated to the ESOP will greatly limit the cash available to reinvest in the business over the long-term, an ESOP is unlikely to be a good fit. While there are costs associated with the outright sale of a company, they typically total a lower cost than an ESOP, and almost always if the owner is able to obtain a higher price on the market.
Additionally, an ESOP may leverage the Company substantially, and oftentimes conservative business owners that have operated with little to no debt have a very difficult time imagining their company strapped with millions of dollars of debt.
It’s also important to consider the profitability of the company. If the company isn’t turning a healthy profit, the share price will decline and the company may encounter a situation where buying out retirees conflicts with necessary continued investment in the business. An ESOP is not a practical option for distressed companies.
Discretion in Succession
ESOPs do not allow for a transfer of ownership to specific people. If your hope is to pass the majority of your company onto a successor, such as a child or family member, you will not have the discretion to do so. Although there are some exceptions, generally all full-time employees over 21 participate in the plan. Allocations are made either on the basis of relative pay or some more equal formula. As employees accumulate seniority with the company, they acquire an increasing right to the shares in their account, a process known as vesting.
A lot of employers are also uncomfortable with the idea of having many employees own the business. While taking on ownership often boosts morale and adds motivation to the shareholding employees, the owner may prefer to find a single successor who shares their vision for the company’s future and is able to execute as a leader. One of the disadvantages of ESOPs is that employee ownership could make for too many cooks in the proverbial kitchen.
Regulatory Scrutiny
A final disadvantage of ESOPs is that, while you’re not required to give your shareholders full transparency of all of the company’s financials, you do have a set of guidelines to follow in order for the company to receive all of the tax benefits associated with an ESOP. This will require some paperwork on your part to make sure all of your cats are wrangled. While this may be worth the payoff for some companies, small business owners often find these restrictions uncomfortable. After all, a common attribute of the entrepreneurial spirit is the attraction to freedom and making your own rules.
There are plenty of myths surrounding ESOPs that may give them a bad rap, but for small businesses, there are some legitimate reasons to think long and hard before making a decision to go ESOP.
If you have decided you’d rather find a qualified buyer, please contact Calder confidentially!