From the June 2012 issue of Investment Advisor • Subscribe!

Seven Misconceptions About ESOPs

Overcoming these misconceptions can unlock retirement assets tied up in clients’ businesses

Illustration by Ellen Weinstein Illustration by Ellen Weinstein

A treasure trove of baby boomer assets are buried in business ownership. LIMRA estimates pre-retirees have $4.8 trillion of net worth tied to the value of the businesses they own. One key to unlocking those assets is an employee stock ownership plan (ESOP). ESOPs can help business owners diversify their portfolios and plan for their eventual business exit. ESOPs also represent a significant untapped opportunity for financial professionals who would be in the position to help business owners invest the assets as well as get access to risk protection products.

An ESOP is a qualified defined contribution retirement plan that invests primarily in the stock of the sponsoring corporation. ESOPs are unique in that they can borrow money to purchase the stock from the selling shareholders. ESOPs are useful in helping business owners diversify their portfolio, plan for ownership succession of the organization and help their employees prepare for retirement.

 While ESOPs have been around since the passage of ERISA in 1974, there are a number of misconceptions that may prevent business owners from considering them. By addressing these misconceptions, you can help clients evaluate whether an ESOP is right for them based on their personal financial goals and their objectives for the company and employees.

1. The owner will lose control of the company. An ESOP doesn’t change the company’s corporate governance. The board of directors appoints the ESOP trustee, which can be an internal or independent person or group. The ESOP trustee is the legal shareholder and votes the shares on behalf of the retirement plan participants. The board and management remain in control of the company, even when the ESOP owns a majority of the company.

2. The owner will have to sell all of the company. An employee stock ownership plan allows the owner to decide how much of the business to sell and the time line for ownership transition. Often times, the owner will initially sell a minority interest (such as 30%), then complete a second-stage transaction at a later date. This is completely at the discretion of the business owner.

3. The company will have to disclose detailed financial information to the employees. As a qualified retirement plan, ESOPs must provide participants an annual statement illustrating the value and number of shares held for their benefit. There are no other financial disclosures required. Some companies elect to share greater amounts of information to engage employees, but it is entirely up to the company to decide.

4. The transaction costs of an ESOP are too large. ESOP transaction costs are very similar to the costs that would be incurred by selling to an outside party or to a family member. Regardless of how a business owner transitions ownership, accountants, attorneys and valuation companies are typically hired to make sure the transaction is completed at fair market value and that the sale is in good order.

As with other types of expenses, a competitive bidding process may help reduce the out-of-pocket costs to the business.

5. ESOPs are difficult for employees to understand and appreciate. Because the majority of the plan’s assets are company stock, it may actually be easier to understand an ESOP than other retirement programs. As in other qualified retirement plans, ESOP participants can see their account balance change over time.

Many ESOPs use comprehensive communication plans that not only highlight the program, but offer education about how the employees can enhance company performance and therefore the value of their account.

6. With an ESOP, the owner isn’t getting full value in the sale. ESOP transactions must be executed at a price no greater than fair market value, as determined by an independent appraiser. The owner has the ability to share in the upside potential of the business to the extent they retain partial ownership.

Consider a scenario where the owner has sold 30% of the company to the ESOP. If the value of the business increases, the owner will benefit from the appreciation on the 70% of the company he or she still owns. But if the value of the business declines, the owner has reduced the downside risk by locking in the value of the 30% that was sold to the ESOP.

7. Only very large companies can put an ESOP in place. Companies of all sizes can benefit from an ESOP. Organizations as small as 30 employees or less have successfully employed ESOPs. The key factors in determining whether a company is a good candidate for an ESOP include:

  • Private ownership
  • Proven business with established markets and clients
  • Solid financials with stable cash flows and profits
  • An experienced management team that is prepared to take the company forward
  • Long-term employees
  • A seller with clear objectives and time frames

You may be wondering why you would promote ESOPs, which typically do not pay you directly for your efforts. ESOPs provide financial professionals with multiple ways to grow their practice. The ESOP creates new investable assets and often produces additional life insurance and estate planning needs.

Helping the business owner with the ESOP can also provide access to other qualified and nonqualified retirement plans.

ESOPs offer business owners a flexible approach to diversifying their portfolio, planning for business succession and helping employees prepare for retirement. Being able to address common concerns opens up this option for employers and reinforces your position as a valued advisor.

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