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Five Best Practices for Implementing an ESOP

Learn five best practices for implementing an ESOP in this article from FORVIS.
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Employee stock ownership plans (ESOPs) can be a powerful ownership succession strategy for certain closely held companies. An ESOP is a qualified defined contribution plan, governed by the Employee Retirement Income Security Act of 1974. While similar to a 401(k) plan in many ways, the primary difference is that an ESOP is designed to invest primarily in the stock of the sponsor company. An ESOP also has a special exception under the law that allows the plan to borrow money to fund the purchase of employer securities. The employer securities purchased with this loan are allocated to participants in the ESOP over a period of time, creating a retirement benefit.

Implementing a leveraged ESOP can be complex. ESOPs are regulated by both the U.S. Department of Labor and IRS. To help ensure a successful ESOP transition, owners should consider the following best practices.

Consider Intangible Goals & Objectives

Before any formal analysis begins, business owners should understand key intangible benefits of selling to an ESOP. Some of these benefits include:

  • Preservation of company legacy and culture.
  • The ability to reward and incentivize both the management team and rank and file employees.
  • The ability to remain actively involved in the business and help ensure a smooth transaction to the next generation of management.

Evaluate Financial Attributes

Although there are no hard and fast rules, most qualified ESOP candidates share a few key financial attributes. Some general financial thresholds may include:

  • A history of generating positive, stable cash flow.
  • Fair market value of equity of $5 million or more.
  • 30 employees or more.

Develop Financial Modeling

An experienced ESOP advisor can help prospective ESOP candidates evaluate the feasibility and structure of the ESOP. Information that may be modeled and evaluated as part of the feasibility study may include:

  • Development of various scenarios including partial versus 100% ESOP ownership.
  • Based on proposed transaction terms, development of company and selling stockholder after-tax cash flow.
  • Development of assumed terms of bank and/or seller financing, including analysis of the ability to use warrants as an interest rate enhancement on the seller debt.
  • Development of potential equity incentives to the leadership team.
  • Analysis of potential tax implications and opportunities available to company and selling stockholders.
  • Development of assumed future company stock value.
  • Development of terms of ESOP loan (internal loan between company and ESOP) and projection of annual ESOP contribution rates.
  • Development of projected employee contribution rates and account balances within the ESOP.
  • Development of company tax considerations and analysis, including review of current corporate structure to determine what restructuring may need to be done pre-ESOP, as well as reviewing potential tax opportunities.

Interview & Engage Qualified ESOP Advisors

After completion of the financial modeling, a business owner should have a much better understanding of whether an ESOP is right for them and their company. If it is, the next step is to interview and engage qualified ESOP advisors. The company will need to hire corporate ESOP legal counsel, as well as an ESOP trustee. The best practice usually includes interviewing two to three ESOP trustees before making a selection. When interviewing potential advisors, be sure to ask about their experience working with other ESOPs and their level of involvement in the ESOP community.

Discuss With Interested Stakeholders

In transactions where the ESOP is purchasing control, certain third parties may require consent for the transaction. Impacted parties may include the senior lender, key customers, or the lessor. For construction companies, it is important to work closely with surety. It is critical to keep any interested third parties informed of the potential transition to an ESOP and be sure they are comfortable with the structure. Closely communicating with these parties can help keep the transaction on track and avoid unnecessary delays.

ESOPs can be a viable succession planning vehicle for owners of privately held businesses. However, it is essential to follow certain best practices to help ensure the ESOP is a good fit for the owner and structured in a way to set up both the company and ESOP for success.

For more information, please reach out to a professional at FORVIS.

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