In the United States, there are two primary methods for employee ownership of a company. Either a large group of employees owns the company outright or there is an employee stock ownership plan (ESOP) in place. ESOPs were first created in the 1970s by the U.S. government, through legislation, and have become a common way to encourage employee ownership.
The structure of an ESOP is straightforward. The company creates a trust, then contributes to it. Stock is then allocated to individual employees based on several different criteria, including position, pay, and tenure. Employees can contribute to the trust as well. Neither party then pays taxes on their allocations until distributions are made from it.
Here are the pros and cons of structuring a company to be employee-owned.
List of the Pros of Employee-Owned Companies
1. It gives employees an incentive to achieve success.
When a company achieves success and is structured with an ESOP, then the employees get to share in that success. This process helps to boost morale within the organization, while encouraging brand growth at the same time. People are more likely to share ideas and embrace innovation if they know there is a reward for its successful implementation later on down the road.
2. There are several investment and tax benefits.
Several different benefits are available through an ESOP that other company ownership structures cannot provide. The principal amount from an ESOP loan can be tax-deductible. That means a loan financed by the ESOP can be paid using pre-tax money. If certain requirements are met, shareholders who sell can indefinitely defer any capital gains taxes which are associated with the sale of their shares. For S-Corp companies, an ESOP’s recognized earnings are typically exempt from income taxes as well.
3. It allows owners to turn their stake into liquid capital.
For companies that are closely held in ownership, the creation of an ESOP allows for an ownership transition to take place. The shares of ownership can be gradually converted into liquid capital that is usually diversified. Not only does this allow the owners to eventually sell out if they wish, it is an opportunity for them to increase the actual value of their ownership stake too. That creates an actual value for the ownership of the corporation.
4. ESOPs permit an immediate ownership transition.
Some business owners may not wish to have a gradual transition toward liquidity. Some may wish to get out of their ownership stake immediately. An ESOP permits this as well. Although the value of an immediate transition is usually lower than a gradual transition, this structure prevents third-parties from coming in to take over the brand. It keeps ownership stakes internal, which can be important if there are several minority owners thinking about liquefying their stake in the brand.
5. It allows for more effective internal controls.
Compared to external sales, an ESOP structure provides business owners with more control over the transition. It also provides better controls for the transactions which take place. Not only do the owners benefit from the stock structure, employees can see increases in their net worth as well. It is an effective way for some to plan for a retirement, especially if other options, such as a 401k or IRA, have not been used.
6. Privately-held companies have certain purchasing obligations.
When an ESOP is in place, participants who terminate their participation because of retirement, disability, or death benefit from the obligation to repurchase their shares. With careful planning, the organization benefits from this process because they can fulfill their obligation while filling the newly opened position for added cash flow. The shareholders benefit because they receive a payout from their ownership.
List of the Cons of Employee-Owned Companies
1. It eliminates the benefits of strategic buying.
The shares of an ESOP can be sold for their full fair-market value. That means an ESOP is a financial buyer instead of a strategic buyer. Strategic buyers often pay more for shares when they feel there is a strong potential for growth. That means the current shareholders in a company that transitions to employee ownership are not likely to maximize their proceeds from a long-term perspective.
2. Financing may be difficult to obtain for some ESOPs.
Outside lenders are often wary of providing financial products to investors who are interested in a complete purchase of an employee-owned company. Financing the full purchase price of the company stock from the ESOP carries with it some risk. That means seller financing may be required to complete the sale of a company when a 100% stake is offered for sale.
3. There are fees which must be paid.
Any stock ownership plan requires administrative work. ESOPs have annual valuation costs to consider, plan administration costs, trustee fees, and other various fees that are associated with the plan. Depending upon the size and scope of the ESOP, this could create an expense of several hundred dollars for each employee. If a company is owned outright by employees without an ESOP, this issue disappears.
4. It requires broad shareholder ownership.
Without broad shareholder ownership, there can be limitations to the available liquidity within an ESOP. This occurs most frequently when a key shareholder utilizes an ESOP transaction to create liquidity for themselves. Because key shareholders can corner the market on available liquidity, no one else would be able to pursue a transaction.
5. ESOPs can also create a cash-flow drain.
When corporate earnings are unpredictable or volatile, then ESOPs create some financial risk for the company. When cash flow is already dedicated to the ESOP, it limits the amount of cash that can be used in other areas of the business. That may limit reinvestment opportunities, research, or innovation, which could then suppress future earnings and sales growth. Some factors, such as death and disability, are impossible to predict and could create an immediate negative impact.
6. There are distribution restrictions to consider.
If a selling shareholder decides to use a tax-free rollover for their ESOP transaction, then no portion may be allocated to themselves or direct family members, including their children. For some family-owned companies with children involved in organizational management, their participation in the ESOP is automatically excluded. Shareholders with more than a 25% share of the stock are also excluded from participation on those shares.
These employee-owned company pros and cons indicate that with careful planning and stable finances, corporate owners and employees can benefit from this structure. There are certain exclusions that must be considered before implementation and the cost of fees must be budgeted to avoid the potential negatives of this structure. When done correctly, everyone becomes invested in the success of the organization.
Blog Post Author Credentials
Louise Gaille is the author of this post. She received her B.A. in Economics from the University of Washington. In addition to being a seasoned writer, Louise has almost a decade of experience in Banking and Finance. If you have any suggestions on how to make this post better, then go here to contact our team.