A Stake in the Outcome: Should You Consider an ESOP? Maybe so, if it kills two birds with one stone.

It’s fundamental: to play the Great Game successfully, employees need to have a stake in the outcome.  Otherwise, it’s hard to imagine why they would go to all the extra trouble to help the company boost its performance.  But what’s the best way to provide that?

If you’ve attended the Gathering of the Games (GGOB’s great annual conference), no doubt you’ve seen sessions offered on the subject of the employee stock ownership plan, or ESOP.  You may even have picked up bits and pieces of information, but don’t yet know the full story. With October being “ESOP Month,” there’s no better time than now to learn more.

To complicate things, there is a lot of misinformation circulating about ESOPs.  Let’s see if we can set the record straight.  Who am I to take this on?  I’ve been working with ESOPs since 1984.  I served as deputy director of the ESOP Association trade group.  Worked at the Labor Department where ESOPs are regulated.  Headed up human resources at a foodservice company in Silicon Valley.  And since 2000, I’ve been with the Beyster Institute, an organization founded by entrepreneur Bob Beyster and now part of the business school at the UC San Diego.   We’re the “stake in the outcome” people, specializing in helping companies develop programs for giving employees a stake in company success.  Credentials established?  Let’s jump in!

There is a ton of research showing that, done right, putting stock ownership in employee hands leads to higher profits, faster growth, and improved productivity.  But that’s not the main reason that business owners use them.

At least 30,000 companies have created ESOPs since 1975 – nearly all at private firms.  And the great majority of those ESOPs got started because the owner wanted to turn some of his or her “on paper” equity value into actual, liquid cash – and do so on highly tax-favored terms.  That’s what ESOP’s are good for, in a nutshell: yes, providing a stake in the outcome by giving employees a chance to build wealth; but even more so, enabling a company’s owner(s) to liquidate any portion of their ownership they may wish to, while minimizing taxes.

So What Exactly Is an ESOP?

Technically, an ESOP is simply an employee retirement plan – a “qualified” plan eligible for special tax treatment.  But in actual use, the function of an ESOP is to buy company stock and hold it as a retirement investment for the company’s employees.  To facilitate this, ESOPs are authorized to borrow money to finance stock purchases.  This means that if you own a private firm, you have a way to sell that stock – whether just a few shares, a major portion, or the whole enchilada.

That’s myth #1 to bust: there are no rules prescribing how much stock you can sell to an ESOP.  Whether 1 percent or 100 percent, that’s a decision the ownership gets to make.

What Advantages Does an ESOP Offer?

1. Selling a part interest.  With other buyers, a sale is likely to be an all-or-nothing proposition – sell them the business or don’t sell it.  With an ESOP, you can sell any portion of the company you want - liquidates some value if you like - while retaining control of the business.
2. Big tax advantages.  As a rule of thumb, a stock sale to an ESOP can produce tax savings that equal the entire price paid by the ESOP for the stock.  So, if an ESOP purchases $1 million of stock from you, that will generate about $1 million in tax deductions/deferrals, spread among the company itself, the selling owner, and the employees.
3. No adversarial buyer across the table.  You get to control the terms of deal.  Set up a sale when you want; in the amount you want – however you want to proceed, limited only by the law, not what an adversarial buyer is demanding.
4. The company gains a strong future.   Sell out to an ESOP and the company (and your employees) continues to operate with a promising future.  Sell to a conventional buyer and your firm may be merged, moved or otherwise torn up, ceasing to exist as an independent concern.
5. It gives employees a stake in the outcome.  The stock sold to an ESOP will, over a multi-year period, be allocated to individual retirement accounts of the company’s employees, giving them a long-term stake in the growth of the company.

So is an ESOP the right way for your company to give employees a stake in the outcome?  That may depend.  If the idea of buying back stock from a current shareholder is appealing, you might be able to accomplish two important goals at the same time.  That could truly make it an effective way to go.

Killing two birds with one stone – how does that strike you?

If you're ready to learn more about ESOPS, look out for my next blog: What Exactly Are the Tax Savings Available through an ESOP?

Martin Staubus is the executive director of the Beyster Institute, part of the Rady School of Management at the University of California, San Diego.  The Institute was established by entrepreneur Bob Beyster, who founded and built SAIC, a Fortune 500 company.