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ESOPs: Empowering Employees and Establishing an Endgame

 

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Introduction

 It is well established that starting a small business differs greatly from forming a giant corporation. There is less spotlight that falls on the business’s operations after its formation or on its long-term fate. Yet important questions persist during these later stages. How can a small business keep its employees engaged in the business? It’s an especially relevant concern for small businesses, because they can often rely on having a tight-knit group of workers who believe in the company. And what happens to the company when the founder sells up or retires?

 Employee Stock Ownership Plans (ESOP) are one option to answer both of those questions. ESOPs distribute shares to the business’s workers, giving them part ownership in the company. And ESOPs can simultaneously set up a succession plan: the company will pass from founder to employers. These benefits, and others, have seen a minor surge in the popularity of ESOPs in recent years.

 Definitions

ESOPs are a means of giving a company’s workers ownership of the company, a concept that has come into vogue in recent times. As the name suggests, this is done by giving employees shares in the company. More specifically, ESOPs function as retirement plans. To become an ESOP company, the owner sells the business to a trust. The trust owns all the shares. The trust’s beneficiaries are the employees. When employees retire, the trust buys their stock. http://www.michbar.org/file/barjournal/article/documents/pdf4article4044.pdf

ESOPs are thus similar to a 401(k). There are a few key differences. One is that ESOPs typically invest only in the company’s own stock, while 401(k)s offer a broader range of investments. Another is that 401(k)s require employees to invest part of their own paycheck. In ESOPs, it is the company that invests its money on behalf of its employees. This opens up participation for employees who cannot afford to deduct part of their paycheck. https://esopassociation.org/articles/esops-vs-401k

 Advantages and drawbacks

In addition to providing employees with a source of retirement income, ESOPs bring one other obvious advantage. As a form of employee ownership, they give employees more of a direct stake in the company. Employees might feel more closely tied to the company, boosting their morale and productivity. https://miceo.org/employee-ownership-101/

That benefits company owners as well. There can be other reasons that owners might adopt ESOPs. Just as ESOPs serve as a retirement plan for employees, they can be a route for owners to retire or move on from their company. Planned far enough in advance, ESOPs can eliminate an owner’s worry about how he or she will find a buyer and move on. That can be a particularly vexing process for smaller businesses. https://mibiz.com/sections/small-business/sharing-the-wealth-esops-offer-business-owners-an-exit-strategy,-if-they-plan-ahead And passing the company on to its employees can give peace of mind in other ways. Passing the company onto its employees means a greater chance of the business maintaining continuity. https://grbj.com/uncategorized/esops-present-tax-savings-opportunity/

A more quantitative benefit involves taxes. The purchase of its own stock is a deductible expense for the company. And if a company is 100% owned by an ESOP trust and is in the form of an S-corporation, the company’s profits are not subject to federal income tax.

Statistics highlight other advantages. Participants in ESOPs have higher retirement savings than those in other retirement plans. ESOP companies have experienced a number of benefits, such as higher growth and stability. https://esca.us/michigan/

But ESOPs are not a cure for everything. These benefits come at a cost – literally. ESOPs require a hefty sum to set up in the first place as well as maintain. For owners looking to use an ESOP as a means to move on from their company, an ESOP will also limit the price they can earn from selling the company. ESOPs restrict selling owners in other ways. ESOPs often require a more drawn-out transition and thus more advance planning. And given that it’s the employees who own the company, the owner cannot pass his/her business onto a specific individual, such as a family member. https://www.caldergr.com/esops-fables-potential-cons-disadvantages-of-esops-for-small-businesses/

There can be issues for the employee as well. Some employees will find tying their retirement funds to the performance of one company (i.e. their employer) a bit too risky. Many companies, however, offer ESOP and 401(k) options simultaneously. This can allow such employees to diversify their retirement investments.

The tag of ‘employee ownership’ might also create confusion. Under ESOPs, employees get shares, which is a form of ownership. But they do not control the direction or governance of the company the way they might in a worker cooperative, another form of employee ownership. And because it is technically a trust that holds the shares on behalf of the employees, the employees cannot trade the shares.

 Recent developments

ESOPs themselves are not a new concept. Congress wrote them into the law in 1974. But they have garnered a great deal of interest recently. Michigan legislators introduced a pair of prospective bills to support ESOPs. The first would have required the Department of Labor and Economic Opportunity to work with the Michigan Strategic Fund to assist in the creation of employee-owned businesses. https://www.nceo.org/employee-ownership-blog/article/michigan-bills-would-encourage-employee-ownership

 The second bill would have given an income tax deduction if a business were sold or transferred to one or more employee, or converted to an employee-owned business. ESOPs, among other forms of businesses, would have fallen under the definition of employee-owned businesses.

Neither bill saw any further progress after being referred to committees, and the legislature has moved onto a new session. http://www.legislature.mi.gov/(S(314pi33kckeehhfne53wkoeq))/mileg.aspx?page=GetObject&objectname=2019-HB-5201 http://www.legislature.mi.gov/(S(p3gxcbn5furcijolmakmeooq))/mileg.aspx?page=GetObject&objectname=2019-HB-5202 The first bill also did not provide for any funding, putting into doubt its would-be efficacy. These setbacks reflect the reality that while ESOPs have captured the imagination of some, they are still a niche option.

 Additional reading:

https://esopassociation.org/articles/how-to-establish-an-esop

https://www.nceo.org/articles/comprehensive-overview-employee-ownership



By: Wooyoung Lee

 


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