An Employee Stock Ownership Plan (ESOP) can be a great option for business owners who are developing a succession strategy, providing an additional retirement benefit for employees, or hoping to achieve diversification, but is it right for your company?

To answer this question, Doug McClure, CEO of Global Investment Strategies, suggests an analysis that starts on a macro level, and drilling down to detailed analyses if the situation makes sense.

20,000 Foot View – Goals and People

Seller’s Objectives: Answers here revolve around timing of exit.  Does the seller wish to maintain an active role in the business, or get out as soon as possible? Answers will impact the modeling and sustainability of the ESOP.

Successors: Consider who will run the business when the seller exits.  This management team is critical for sustainability of the company, and therefore sustainability of the ESOP.

Critical Relationships: Determine what is necessary to retain employees with the most experience and skills, and ensure the ESOP takes into consideration critical customer and vendor relationships.

Participation: Consider your employee base, including payroll size, participation and eligibility. Independent contractors and unionized workers are typically excluded from participating in an ESOP.

Stability & Culture: Trust in management and effective communication are key to a successful plan. The incorporation of an ESOP should fit the current dynamic of your company’s culture and morale.

10,000 Foot View – Financial Feasibility

A few key characteristics can help determine if your company is financially prepared to support an ESOP, including:

  • A strong record of growth and profitability
  • Reasonable debt capacity
  • Recurring cash flow
  • Sufficient payroll

Potential barriers to a successful ESOP include:

  • Start-up companies
  • Unrealistic expectations of company value
  • An excessive reliance on strong economy
  • Small customer base
  • Unresolved legal claims against the company
  • Clouded title to stock
  • Informal corporate and financial records
  • Environmental liabilities

5,000 Foot View – Designing Your Feasibility Study

Determining the motivation for establishing an ESOP helps dictate the process. Whether a shareholder wants to be cashed out or the company is in pursuit of a long-term transaction, identifying the objective for the transaction is the first step in the feasibility study process.

Next, educate the decision makers. Make sure the purpose, process and benefits of an ESOP are fully understood, such as the deductibility of principal and interest, deferred gain on sale to ESOP and S corporation tax exemption.

Then, assemble an external team of consultants and advisors, including an ESOP consultant, appraisers, attorneys, accountant, trustee, record-keeper and communication consultant. Identifying these individuals will prove vitally important to the success of the plan.

In designing the feasibility study consider succession planning, transaction structure, impact to other shareholders and repurchase liability.  Components of the study include:

  • S or C corporation
  • Leveraged or non-leveraged
  • Percentage of ownership
  • Sale to ESOP, redemption, or combination
  • Financing alternatives
  • Repurchase liability

Ground Level – Model the ESOP

  • Build a base case using revenue and income projections provided by the company.
  • Build alternative ESOP scenarios using adjusted revenues or profitability to demonstrate how the company will fair under certain potential circumstances.

Upon completion, the analysis will illustrate the potential impact of the transaction on the company’s cash flow and help to determine if enough cash is available to finance day-to-day business activities and growth. It also demonstrates the impact to shareholders and what the ESOP could look like from an employee benefit perspective.

A feasibility study may also estimate timing and amount of funding needed for future repurchase liability. Additionally, the study will take into account various legal limitations and 409(p) anti-abuse rules, if applicable.

ESOP Implementation

The results of a feasibility study are typically presented to the company’s board of directors or ESOP committee who will determine if the formation of an ESOP is an effective strategy for achieving shareholder and company objectives.

If the decision is to move forward with the transaction, the study will be helpful in designing the core elements of the plan. In the end, the company will have a much better understanding of the appropriate strategy for ensuring the long-term success of the ESOP and the business.