ESOPs: Advantages and Disadvantages
What is the Principal Reason to Use an ESOP?One of the problems that entrepreneurs and family business owners face is that there is no established market for their shares. This means that it is very hard for them to sell only a part of their business. They may want to liquidate some of the personal wealth that is trapped in their company without selling the whole company. They often want to do this in order to reduce the risk to themselves and their families of having "all their eggs in one basket".
Unlike many other succession planning strategies, use of an ESOP can have tax advantages both for the selling shareholder and for the corporation. For this reason, the after tax cost of an ESOP purchase can be substantially lower than a redemption of the owner's shares or an outright sale to a third party.
What are Some Other Advantages of Using an ESOP?The selling shareholder can usually retain substantial control over the company that is now partially or wholly owned by the ESOP. The selling shareholder may not want to give up control of their company to an outside buyer who may not continue the selling owner's business philosophy. By selling to an ESOP the selling shareholder will be able to protect the legacy and culture of the business they have built and nurtured. The company will not become an anonymous division of an absentee buyer.
Employees of the ESOP owned company will have a substantial, tax sheltered retirement benefit that will grow with the growth and prosperity of the company. Using an ESOP can help the selling shareholder protect the valued employees of the company from the layoffs that usually result when third party financial buyers purchase closely held companies.
What are Some Disadvantages of using an ESOP?ESOPs can be expensive to implement. ESOPs are complex, and they require knowledgeable professional advisors, including accountants, valuators, and attorneys and feasibility consultants. Even so, the cost of implementing an ESOP is generally not more than the cost of an outright sale or any other succession or exit strategy. ESOPs require annual valuations, but, generally, the annual valuation is much less expensive than the valuation at the time of the sale. ESOPs require careful recordkeeping, but there are many excellent ESOP record keepers. Periodically, Congress changes the rules governing ESOPs. The changes are almost always quite small, but they usually require amendments to the ESOP Plan and/or Trust documents. Every five years, the company must submit the ESOP Plan and Trust documents to the Internal Revenue Service for a review. Both the required changes and the periodic submissions will incur some fees. The IRS also charges a filing fee for the five year review.
ConclusionUsing an ESOP to purchase shares in a closely held or family corporation may be an excellent tool for an owner who wants to cash in all or a portion of the business. Unlike most other succession strategies, the ESOP allows the selling shareholder to phase out of ownership, slowly and carefully relinguish control, maintain the legacy and values of the company and protect skilled and loyal employees. An ESOP advisor with a solid knowledge of other possible successsion strategies can help you decide whether an ESOP is right for you.