Employee stock ownership plans (ESOPs) can be an attractive way for an owner to sell a company and for employees to gain an ownership stake. ESOPs are qualified retirement plans that buy, hold and sell company stock for the benefit of employees. One of the main reasons ESOPs are often dismissed by business owners (and often their advisors) as a legitimate succession planning option is due to the many unfounded misperceptions about them.

In reality, many businesses are a perfect fit for ESOPs. However, business owners will never know because they think selling to a private equity or other third-party buyer are their only legitimate alternatives.

Here we will help dispel some of the most common myths associated with ESOPs. After reviewing the facts behind the fables, business owners will see that selling to an ESOP might be the best alternative and should be at least considered as an exit strategy. This is especially true in cases where the owner wants to reward his or her employees for their hard work in contributing to the company’s success.

Myth #1: After establishing an ESOP, a business owner must consult with employees on day-to-day management decisions.

Fact: Business continues as usual the day after a company becomes an ESOP. The officers of the company (president, CEO, other key leaders) make the decisions in ESOP companies (just like most non-ESOP companies), and they answer to the company’s board of directors. The board of directors should change following an ESOP transaction, particularly one where majority control shifts (i.e., more than 50% of the stock is sold to the ESOP).

Myth #2: ESOPs are too expensive to the selling business owner.

Fact: Other succession planning alternatives (such as use of a business broker or investment bank) are much more expensive than ESOP expenses. For example, in most third-party sales with a business broker or investment banking f irm, a commission or “success fee” will be charged as a percentage of the sales price. This amount often far exceeds what would be charged for an ESOP transaction, which is done on an hourly or fixed fee basis. Moreover, because of the tax advantages (state and federal) which may apply to ESOPs, the transaction fees are often minimal by comparison.

Myth #3: ESOPs keep all an employee’s eggs in one basket.

Fact: ESOPs are required to allow up to 50% diversification (i.e., liquidation from employer stock to cash to invest in more traditional investments like mutual funds) when a participant reaches age 55 with 10 years of participation in the plan. Also, an increasing percentage of ESOP companies also have a 401(k) plan, which adds another retirement savings opportunity for the employee.

Myth #4: ESOPs are only for large companies.

Fact: Many ESOPs are as small as 12 to 15 employees with less than $1 MM in annual revenue. Profitability of the company is more important than size. The company just needs to be large enough to generate a profit to substantiate the annual costs of maintaining the ESOP. In profitable S-corporation ESOP companies, the tax savings should be more than enough to offset such annual costs.

Myth #5: An ESOP transaction requires that a majority of stock be transferred.

Fact: ESOP transactions can be done for as little as 1%, and as much as 100%, of a company and everything in between. Yet, many business owners eventually end up selling all of their stock to the established ESOP because it is a “willing buyer” and the tax advantages of being a 100% ESOP-owned company are too tantalizing to resist.

Myth #6: An owner adopting an ESOP will get a lower exit value by selling to an ESOP than by selling through the open market.

Fact: This issue is often the elephant in the room from a valuation perspective. While a seller may get nominally less by selling to the ESOP, the tax savings generally make it comparable to selling to a private equity firm or another buyer. ESOPs generally increase the after-tax proceeds of a sale. The company can also take a tax deduction of up to 25% of payroll by making an ESOP contribution. Selling to an ESOP can also eliminate the ongoing tax or S-corporation distribution obligations of the company providing significant ongoing tax savings.

Myth #7: The Department of Labor (DOL) is heavily focused on ESOP valuations. Those who adopt an ESOP may become a target.

Fact: Several lawsuits by ESOP participants post-2008 led to some additional scrutiny by the DOL about the stock valuations of ESOPs. When valuations fell post-2008, some questioned whether companies inflated valuations when creating the ESOP. The good news is that this scrutiny led to very clear guidance from the DOL on how to properly value ESOPs. This new guidance spells out a detailed process that requires independent valuation and the avoidance of conflicts of interest. In fact, the new valuation guidance may reduce the risk of DOL scrutiny.

Myth #8: ESOP companies are less competitive in the marketplace than non-ESOP companies.

Fact: An S-corporation ESOP actually has a distinct advantage over non-ESOP companies due to exemption from federal/state taxes (more than 80% of states follow the federal rule). The tax savings can quickly accumulate and the cash can be used for reducing debt, capital investment or even making acquisitions.

VRC performs fairness opinions in connection with newly forming ESOPs and annual ESOP valuations. Our valuations include both those for plan initiation and those required annually under federal law. For a more in-depth conversation about how we can work with your firm’s ESOP, please feel free to contact a VRC professional.