Is now the right time to offer stock options to employees?

Employee stock ownership plans can help to prepare owners for an exit as well as reward employees. Is it the right fit for your company at this time? As a business owner, you may be concerned with the amount of your net worth that’s tied up in your business. If it represents a large percentage of your overall wealth, you may be considering how to transfer it to the next generation and, at the same time, you may be wondering what other tools you could employ to attract and retain employees.

An ESOP is a tax-advantaged defined contribution plan in which employees own shares through a trust that the company funds. As of 2022, the National Center for Employee Ownership estimates that there are approximately 6,500 ESOPs covering almost 14 million participants. Employees participating in an ESOP can purchase the stock directly, receive it as a bonus, be given stock options, or obtain stock through a profit-sharing plan.

Shareholder and company benefits

Some of the benefits for the selling shareholders include providing liquidity while allowing them to retain control of the company. Because a trustee will negotiate transactions privately, sensitive information won’t be divulged to possible competitors. Additionally, when you sell shares to an ESOP, there’s the potential to defer payment of federal income taxes, such as capital gains post-transaction, in certain circumstances.

For the company, owners can use tax-free or tax-deductible dollars to pay down debts, and cash contributions and contributions of stock are both tax-deductible. As far as employee retention goes, the median job tenure was 53% higher for companies with an ESOP, according to research done by the National Center of Employee Ownership and Rutgers University. During this time of “The Great Resignation,” that is a powerful statistic. The same study found a 2% higher sales and employment growth year after year versus non-employee-owned businesses, leading to a higher equity value for the sponsor company.

Impact on the employees

The employees can also benefit from an ESOP and don’t pay income tax on the stock put into their ESOP accounts. A 2018 study found that ESOP participants had more than twice the average total retirement balance of Americans nationally, which is a game-changer regarding their quality of life in retirement.

Companies that would be a good fit for an ESOP are those that are profitable since it will allow the company to reduce its taxable earnings by the amount used to fund the ESOP. In fact, the trustee may object to the ESOP buying the stock if a company is not profitable.

If you are thinking about selling to your employees, selling them company stock can be an exit strategy, allowing them to own the business upon the owner’s exit. This also begs the question – how do you feel about someone else running your company? The rank-and-file employees participating in the ESOP would have voting rights, though existing board of directors and managers would still be in place.

An ESOP may not be a good fit if you want to make a significant profit selling your company. It can only pay fair market value for your company’s shares if your stock is a publicly traded security or based on the valuation performed by an independent valuation expert if your company is not publicly-traded. ESOPs can only be used by S- or C-Corporations. In addition, a departing employee’s shares must be repurchased if you have a private company. This could mean a considerable expense in the future if many workers were to leave simultaneously. They can also have a substantial setup cost, and if you issue additional shares, the stock of existing owners is diluted.

Starting the ESOP valuation

If you have determined your company’s need for an ESOP and have gone through the due diligence of a feasibility study and valuation, you are now at the point of establishing a trust to buy your stock. A trustee will need to be appointed to oversee and operate the plan. The owners will also need to determine how to fund the plan, which can be done through company contributions, funds generated through other investments, or often through financing. Often the ESOP borrows money based on the company’s credit to buy the owner’s shares, and the company then makes contributions to the plan to repay the loan.

An ESOP will help owners to establish a transition plan for their business in which they can sell gradually while creating a market for your company’s stock. It also fosters a culture of ownership within the company. Owners will need a valuation expert, a trustee, and an experienced ESOP advisor or attorney to keep them in compliance with IRS rules and regulations. It would be wise to anticipate living expenses after an owner leaves the business and consult an account and financial advisor to ensure that they are prepared for the next phase of their life.

Bevin Baker is a financial advisor at Fort Pitt Capital Group.