Employee Stock Ownership Plans (“ESOPs”) are qualified, defined contribution employee benefit plans that invest primarily in the stock of the sponsoring Company. Being “qualified” simply means that the Company sponsoring the ESOP receives various and significant tax benefits. “Defined contribution” means the Company makes annual contributions to the ESOP, as opposed to providing a defined, guaranteed benefit. ESOPs provide an opportunity for business owners to enjoy a partial or total tax-advantaged exit while also affording employees an incredible, tax-deferred wealth-building opportunity.
Generally, all full-time employees aged 21 and older participate in the ESOP. Shares are allocated to individual participant accounts based on a fair allocation formula, which is typically compensation. There are vesting requirements and participants normally receive stock or cash after they leave the Company. The Company has flexible payout options available as permitted under the Employee Retirement Income Security Act of 1974, as Amended.
Most ESOPs are leveraged, meaning that the ESOP borrows funds to purchase stock from business owners. Leveraged ESOPs provide meaningful tax advantageous while shares are allocated to employees over time. ESOPs can also be non-leveraged, meaning the ESOP does not borrow funds. Instead, the Company contributes newly-issued shares, cash, or both, to the ESOP. The non-leveraged ESOP is typically a pure contribution plan, with contributions determined at the discretion of the Board of Directors.
At their core, ESOPs are essentially three things: 1. an ownership transition tool, 2. an employee retirement benefit and 3. a tax-advantaged exit strategy.
Ownership Transition Tool
Owners Sell Stock to ESOP
- Total or Partial Ownership Transition
- Controllable Sale Transaction
- Capital Gain Deferral or Elimination if Certain Conditions are Met
- Management Succession Goals
- Sellers May Continue to Run the Business
Employee Retirement Benefit
Employees Build Wealth
- Qualified retirement plan, non-discriminatory, tax-deffered growth for employees
- Company makes a market for distribution (“ESOP put option”)
- Fosters an ownership-minded culture
- Numerous independent studies confirm the wealth-building and corporate outperformance of ESOP-owned companies
Tax-Advantaged Exit Strategy
Unique Tax Aspects
- 100% ESOP-owned S-Corps are exempt from federal & most if not all state taxes
- Can be a tax-exempt company in certain situations
- Tax deductibility of debt payments
- Flexible financing options
Establishing a Leveraged ESOP
The first step is to establish an ESOP Trust, which is funded with one or a combination of either cash, newly-issued shares, and/or borrowed funds to purchase stock. It is important to note that the Company employees only rarely use their funds to purchase ESOP stock. If employee funds are used, it is typically from their individual 401(k) account, with each employee making the investment decision whether or not to rollover their 401(k) monies into the ESOP. In the majority of instances, Company contributions fund the ESOP. These funds typically come from cash on hand or borrowed funds from lenders (e.g., banks, private debt funds, unitranche and mezzanine lenders, family offices, etc.).
The two most common leveraged ESOP structures are summarized below. The first table shows a direct ESOP purchase while the second shows a corporate redemption followed by an ESOP purchase/subscription. The third table illustrates how shares are allocated to employees.
Establishing a Non-Leveraged ESOP
Establishing a non-leveraged ESOP also beings with establishing the ESOP Trust. The primary difference is that the non-leveraged ESOP does not borrow funds. Instead, the Company contributes newly-issued shares to the ESOP, which amount is at the discretion of the Board of Directors. The non-leveraged ESOP can be a pure share contribution plan or the Company can contribute cash to the ESOP, which it then uses to buy stock from the owners. Non-leveraged ESOPs are typically used to “phase in” an ESOP or when the owners do not want to sell stock but desire employees to participate in ownership.
Financing the Leveraged ESOP Transaction
It is common for a Company to borrow funds to effectuate an ESOP Transaction. ESOPs are attractive to lenders due to their enhanced cash flow from tax efficiencies afforded to ESOPs. Common capital providers are listed below.
- Commercial Banks
- Employee 401(k) Rollovers
- Family Offices
- Mezzanine Funds
- Private Debt Funds
- Hedge Funds
- Seller Financing
- Unitranche Lenders
- Most ESOPs are leveraged
- Senior banks provide the least expensive capital
- Seller financing can have unique structural elements and tax advantages (i.e., warrants, paid-in-kind interest).
- Sellers may opt to finance all tranches if desired
- We develop a financing structure that meets the business owners’ goals