|Twelve Bogus Reasons Not to Do an ESOP (and
Seven Good Ones)
By NCEO Executive Director
Over the years, we at
the NCEO have heard a lot of unconvincing reasons not to do an ESOP—and
some very good ones, too. Unfortunately, too many business owners decided
not to do an ESOP for the wrong reasons. Here at the NCEO, our goal is not
to convince anyone to implement an ESOP (or any other employee stock
plan). Employee ownership can grow and prosper only if companies put in
these plans for the right reasons. Our mission is to provide objective,
reliable information about employee ownership that you can use to make a
well-informed, sensible decision. With that in mind, below is a list of
what we call bogus reasons not to do an ESOP, followed by some legitimate
Bad Reasons Not to Do an ESOP
- ESOPs have excessively high legal
and administrative costs, especially for small firms: To be sure, an
ESOP is more expensive than, say, setting up a 401(k) plan, but it is a
lot cheaper than selling a business almost any other way. An ESOP will
probably cost $50,000 to $100,000 to set up and run the first year and,
for most companies with under a few hundred people, $15,000 to $30,000
annually. Selling to another company involves, usually, some tens of
thousands of dollars in legal, accounting, and valuation fees, plus, if
there is a broker, as there often is, another 5% to 10% of the
transaction. There is no broker in an ESOP. So for most sellers of all
but the smallest companies, an ESOP is actually much cheaper than
selling some other way. Setup fees can be more in some cases, depending
on financing sources and whether independent fiduciaries are required.
- The ESOP cannot match what other
buyers will offer: The ESOP will pay what an appraiser determines a
financial buyer would pay (such as an individual investor or private
equity company), but not what a synergistic buyer (such as a competitor)
might offer. However, the ESOP pays cash; outside buyers often pay
partly in cash and partly in an earnout. There may also be financing or
personal contingencies on the sale (such as requiring the seller to stay
or leave). Other buyers also cannot offer the opportunity the ESOP does
for the seller to defer capital gains tax on the sale.
- The employees don't have the funds
to buy the company: That's true. They rarely do. But what is also
true is that in an ESOP they do not use their own funds to buy the
company. ESOPs are funded by corporate pretax contributions to the
employee stock ownership trust. There can be annual discretionary cash
contributions to buy shares each year, or the trust can borrow money to
buy shares with the company making tax-deductible contributions to pay
off the loan.
- Employees must invest in other
retirement plans to diversify their investment: ESOPs are not
diversified, at least in their early years. But having an ESOP does not
preclude the company from having a 401(k) plan or any other kind of
retirement plan. The company may, at least temporarily, suspend any
match or contribution to these other plans, but employees can still make
- Companies have to make a fixed
contribution every year: This is only true if an ESOP is used to
repay a loan, not if the company is making annual discretionary
contributions in cash to buy shares. Even with a loan, it may be
possible to renegotiate a payment schedule.
- Bank credit for an ESOP loan is not
available: ESOP loans have a very low default rate, so banks that
have some experience in this area typically will view them more
favorably than other highly leveraged transactions. If bank credit is
not available, however, sellers can finance the sale directly by taking
a note with the ESOP paying an equivalent arms-length interest rate.
- Companies have to keep repurchasing
their own shares: By law, at some point after employees leave the
company, the company has to make sure the shares get repurchased, either
by the company or the ESOP (or, less often, someone else). But any
closely held company has a 100% repurchase obligation all the time. If
employees buy shares directly, such as in a management buyout, they too
will want liquidity for their shares at some point. The difference is
that with ESOPs, repurchase occurs in smaller bites every year; with
other ownership arrangements, when owners want to sell, the company
either finds another buyer or liquidates.
- Management must share financial
information with employees: There is no such rule. Companies need
only provide annual account statements indicating the total value of the
account, vesting, and stock value. The most effective ESOP companies are
"open book," but it is their choice to do that.
- Younger employees are more
concerned with short-term cash than with potential retirement benefits:
Extensive academic research shows demographics (age, seniority,
education, income, and position) are not predictors of employee
reactions to ownership.
- ESOPs are difficult for employees
to understand and appreciate: They can be if companies don't make
the effort. But they can be explained if you do.
- ESOPs do not improve corporate
performance: The evidence points in exactly the opposite direction.
ESOP companies grow 2% to 3% faster than would have been expected
without an ESOP, and have lower turnover and 2.5% higher productivity.
Profit data per se are not available for closely held companies because
they don't disclose it, but there are lots of proxies. The National
Bureau of Economic Research, no less, has concluded that ESOPs are
significantly correlated with economic performance. The relationship is
not automatic, however. Companies that combine ESOPs with what we call
an "ownership culture" (they share financial information and get people
involved in work-level decisions) grow 6% to 11% per year faster than
would have been expected; companies with top-down cultures grow more
slowly post-ESOP than would have been expected. In other words, an ESOP
works if part of an overall culture, not all by itself. Just having the
culture without the ownership, by the way, doesn't work very well
- You can only do an ESOP in a public
company: That's just not true.
Good Reasons Not to Do an ESOP
- There is a synergistic buyer
willing to offer a substantial premium: If price is the primary
concern for an owner, and there is a synergistic buyer willing to pay a
significant premium, an ESOP may be the wrong choice. Several factors
come into play here. First, the seller must be looking to get out
entirely. Some sellers only want to sell part of their ownership, or
there may be one or more owners who want to sell and one or more who do
not. Second, the premium must be large enough to offset the ability of a
seller to an ESOP that meets the basic requirements (the ESOP owns at
least 30% after the sale, the company is or converts to a C corporation,
the company is closely held, and the owner has held the stock for three
years) to defer taxation on the gain by reinvesting in other securities.
Third, the buyer's offer must not contain unacceptable contingencies or
- Is the company too small? ESOPs
typically cost $50,000 or more to set up, depending on complexity and
the size of the transaction. For very small companies (typically under
10-15 employees), these costs may be greater than potential tax
benefits. If the company is an S corporation, rules aimed at preventing
a small number of people from getting the bulk of the ESOP benefits may
make an ESOP impossible even if all employees are in the plan. The
company could convert to C status, however.
- Is there successor management?
If the seller is the key manager, capable successor management must be
in place to obtain an outside loan as well as to help assure that the
company will be able to pay for the plan over time.
- Is the payroll large enough? In
rare cases where the value of the company relative to the size of the
payroll is very large, limitations on how much can be contributed
annually to the ESOP may make it impractical to buy a substantial
percentage of the company.
- Can the company afford the
contributions? When an ESOP is buying out an owner, the cost is a
non-productive expense. Companies need to assess whether they have the
available earnings for this. ESOPs are not usually good choices for
- Is management comfortable with the
idea of employees as owners? While employees do not have to run the
company, they will want more information and more say. Unless they are
treated this way, research shows, they may be demotivated by ownership.
- Are there family members or
specific executives who want a major share of the company? An ESOP
cannot be used to transfer ownership to specific people. ESOP rules
require that contributions be allocated based on relative compensation
up to (in 2009) $245,000 or some more level formula. Moreover, everyone
who has worked for 1,000 hours in a 12-month period must be in the plan
(with certain exceptions, such as employees covered by a collective
bargaining agreement). Family members and 25% owners also cannot get
allocations of any shares subject to the capital gains deferral.
Individuals can buy or, within reasonable limits, be given shares
outside the ESOP, or be given equity rights such as stock options or
stock appreciation rights. If the goal is to transfer most of the
ownership to a select group, then, an ESOP is not appropriate.
Why Your Advisors May Be Misleading You
Having read this, you may wonder why your
advisors would have given you information that may have been misleading.
There are a few possible reasons:
- They have limited knowledge:
While the honorable thing to do when you have limited information is to
tell your clients that they may want to get some other opinions from
people more knowledgeable in the field, there is a natural tendency to
want to seem more expert than you actually are (think about all those TV
pundits who happily opine about all kinds of subjects they know little
- They had a client or two with an
ESOP that did not work out: Personal experience has a strong
emotional pull. The stories we know can be much more powerful than reams
of data or expert opinion.
- They fear losing you as a client:
This is especially true if the advisor is a business broker. They make
their money by finding a buyer other than an ESOP. ESOP sales do not
(and cannot) involve brokerage fees, which usually are a percentage of
the transaction. I have had more than one broker tell me that even
though their client was a very good ESOP fit, they could not recommend
an ESOP. But other advisors, such as attorneys and accountants, may
worry that if you do an ESOP, you will seek specialized advisors, not
them. It's not that most of these people are intentionally misleading
you, it's just that the pull of their own self-interest may make them
see the world differently. Our experience at the NCEO is that most
professional ESOP advisors are willing to work closely with existing
advisors, and most welcome the opportunity to provide to the existing
advisors the specialized knowledge required.
This is not to say that your advisors are
acting against what they know to be your best interests. But ESOPs are a
highly specialized area, and there is a lot of misinformation out there.
So it's easy to make mistakes. I hope this article will help you avoid
some of them.
Corey Rosen is
Executive Director and co-founder of the National Center for Employee
Ownership. His website is