Employee Stock Ownership Plans (ESOPs)

ESOP Overview

An ESOP is a defined contribution employee benefit plan that allows a business owner(s) to sell all or part of their closely held company to employees. In addition to aligning the interests of employees with management, an ESOP can be used to attain an owner’s goals in business succession planning, estate planning, diversification of assets, or as an exit strategy. With careful planning, taxes on a gain on the sale of stock to an ESOP can be deferred or permanently avoided, making an ESOP a powerful tax planning tool.

A company sets up a trust fund to establish an ESOP and contributes new shares of its own stock or cash to buy existing shares. The trust is governed by a trustee(s) selected by the company’s Board of Directors. Under the Employee Retirement Income Security Act (ERISA) of 1974 and amendments, the ESOP trust cannot pay more than fair market value (also referred to as adequate consideration in the ERISA regulations) for the company stock that it purchases from the selling shareholder. Center Point’s valuation reports are critical in developing a company’s initial ESOP transaction value, as well as the annual valuation updates used for administrative and stock buyback purposes.

There are leveraged and non-leveraged ESOPs. With a non-leveraged ESOP, the contributions to the plan are either in newly issued stock or cash used to purchase outstanding stock, which will then be reissued to employees. The company then funds the plan with cash that will be used to purchase stock back from employees as they retire or leave the company. A leveraged ESOP borrows money from a bank or the company’s owners to buy existing stock. The stock is then placed into an escrow account and systematically released as the loan is repaid. This allows the company the flexibility to defer some of the payments to their employees until the loan is paid off. In addition, loan repayments (both principal and interest) are tax deductible, which helps to offset the reduction in share value as a result of the leveraged ESOP transaction.

The appraiser also must consider the appropriateness and magnitude of control and marketability adjustments to the interest being sold to the ESOP. The provisions found in IRS Revenue Ruling 59-60 are generally required for determining fair market value for ESOP transactions, including the marketability of the shares or lack thereof, and the presence or absence of control. The existence of an ERISA-required put right (the obligation of the company to purchase shares from employees at fair market value), provides a source of stock liquidity but also results in a growing repurchase liability. A control premium may be applicable if significant control passes from the seller to an independent ESOP trustee.

Center Point provides initial valuations related to the purchase of stock by the ESOP and annual valuation updates for ESOP administration. We also provide letter update valuations when ESOP transactions are contemplated at times other than the plan year-end. Valuations are a central component of Employee Stock Ownership Plans (ESOP) and are required by law, with severe penalties for non-compliance.

ESOP Advantages

Employee Stock Ownership Plans (ESOP) are a versatile vehicle through which employees obtain ownership rights in a company. ESOPs offer business owners unique opportunities for both succession and estate planning, thereby providing the business a vehicle for continued growth and success.

Studies show that ESOPs result in less turnover and increase:

    • Employees’ Motivation & Innovation
    • Company’s Profitability
    • Return on Investment
    • Tax Benefits
    • Wealth to Beneficiaries

The following are common characteristics of companies that make good ESOP candidates:

    • Mature with stable cash flow and modest capital expenditures for the foreseeable future
    • Sufficient balance sheet strength to purchase ESOP stock in cash and/or interest bearing debt
    • A history of profitable operations and projected profitability
    • Sufficient base of employees and management depth
    • Effective communication between management and employees