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Home  /  Insight & News  /  Jim Andersen and Claudia Stern Contribute Expertise to Article on Utilizing ESOPs for Business Owners Considering Retirement

Jim Andersen and Claudia Stern Contribute Expertise to Article on Utilizing ESOPs for Business Owners Considering Retirement

  • September, 2019

Thinking about retirement? For those who own a company and are looking to hand control over to their employees, an employee stock ownership plan, or ESOP, might be an attractive option, but it doesn’t come without risks. The North Bay Business Journal interviewed Jim Andersen and Claudia Stern to get their take on this strategy.  

ESOPs allow a company to set up a trust fund to which employees can contribute cash to purchase company stock, contribute shares directly, or have the plan borrow money in order to purchase shares in the company. If the plan borrows money, the company contributes to it to enable it to repay the loan.

A central benefit of ESOPs are that the contributions are not taxed until employees receive their stock when they leave or retire, and owners can sell out of a business over time.

But the plans do carry risk, particularly for owners who risk losing control of their company as they gradually offload shares to employees. It is also possible a business would not generate enough cash to buy out the owner. Employees also see risk, since if a business goes belly up, their retirement savings potentially do, too, with an ESOP.

How can ESOPs be used in business succession planning when an owner is looking to leave a business?

Claudia Stern and Jim Andersen: If an owner decides that the business should be transferred to the employees, this is a tax-efficient mechanism for getting the business to buy out the owner and for the employees to take control.

Because the business is the one cashing out the owner, it is imperative that the business have adequate cash flows to support the buy-out. One of the downsides of this method is that the owner may get paid less for the business because they are selling at fair market value and losing the opportunity to achieve a synergistic sale which would generate a premium over fair market value.
The other downside is that the owner may not be able to sell their entire stake at once, so there is risk that the business may not generate enough cash in the future to complete the entire buy-out process.
What are the advantages of this approach as opposed to other methods?
Stern and Andersen: The primary advantage of this method is its tax efficiency, primarily for the owner but also for the employees. It can also be a great motivator for the employees, as the company will fund a retirement benefit and buy company stock for each employee, and it will be good for public relations.

What are the potential risks of using an ESOP and providing employees with ownership interests in a company?

Stern and Andersen: From the owner’s point of view, the risk is the business will not generate enough cash to buy-out the owner. If the owner is handing over control or selling more than 50 percent of the ownership, the owner may not be able to prevent management from taking on risks or otherwise running the business in a way the current owner doesn’t like.

From the employee’s point of view, the company will be putting retirement contributions into company stock which increases an employee’s financial risk. If the company fails, not only will the employee lose their job but their retirement savings will be worthless.

Finally, there are a lot of risks with the regulatory responsibilities of the ESOP. The ESOP is a trust, and must be run to benefit the employees. Every employee has the potential to file a lawsuit against the ESOP’s trustees and advisers for failing to do their fiduciary duty.

Are companies increasingly considering using ESOPs in the business succession context?

Stern and Andersen: ESOPs were very exciting when they first became available and were often used in situations where they were destined to fail. After seeing succession failures, there is more caution about when they are appropriate and when they are not.

What would be some mistakes a business owner could be susceptible to when going this route?

Stern and Andersen: The biggest mistakes we have seen would involve two issues: First, not enough cash is available from operations to support the buy-back. Second, the current owner remains in control and does not understand the formalities that must be observed when the ESOP is formed, i.e., sloppy accounting and inadequate annual valuations, which led to multiple lawsuits.
Read the full article here: https://www.northbaybusinessjournal.com/industrynews/employment/10064451-181/esop-employee-stock-option-plans-succession
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