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An ESOP can turn your employees into stockholders

Employee stock plansPrivately held companies that want investors need look no further than their own offices. Companies can raise capital through sales of stock to an employee stock ownership plan (ESOP).

An ESOP is a tax-exempt trust that uses borrowed money to buy stock in an employer. The ESOP repays the loan out of dividends and turns the stock over to employees. While the employees "own" the stock, most ESOPs don't permit workers to sell their shares until they leave the company.

Of the 15,000 U.S. companies that share ownership with employees, 10,000 of them do so through ESOPs, and those ESOPs cover almost 9 million participants, according to Corey Rosen, executive director of the National Center for Employee Ownership, based in Oakland, Calif. Most are privately held and many are small businesses with 100 or fewer employees.

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Benefits for owners, workers
Both employer and employees benefit from ESOPs. The advantages are:

  • ESOPs provide an outlet for shares in a private company. It can be difficult for a small business to find buyers for its shares. ESOPs provide a vehicle, says Andy Patterson, a manager at the accounting firm of Horty & Horty P.A., based in Wilmington, Del.
  • They permit business owners to raise capital. An ESOP can borrow money to buy new or existing company shares, with the company repaying the loan by making contributions to the ESOP. The loan proceeds can be used to refinance existing debt, buy out a previous owner, or finance an expansion or other capital expenditure. In fact, entrepreneurs often use ESOPs to finance the purchase of a business.
  • ESOPs provide a tax benefit. If an ESOP borrows money to buy stock, the company repays the loan in pretax dollars.
  • ESOPs are an employee benefit. Companies can contribute new shares to an ESOP and take a tax deduction for them.
  • Employee ownership of shares can lead to increased loyalty and decreased turnover. Both are considered valuable assets in today's low-unemployment economy. In addition, some experts believe that offering employees a stake in a company can boost their productivity, provided that the shareholders can participate in decisions affecting their work, Rosen says.
  • ESOPs provide broad-based stock ownership. Unlike stock options, which are given out on a selective basis, an ESOP gives all employees a chance to have a stake in the company. Generally, full-time employees with a year or more of service at the company are eligible to participate.
Types of employee stock ownership
While employee stock ownership plans (ESOPs) are the most prevalent, there are other ways to get company stock in the hand of employees. Here are the various methods and how they differ:
ESOPs: All employees participate. Shares are allocated to full-time employees with at least a year of service with the company. Employees receive their share when they leave the company. At that point, they can sell them back to the company. Employees own shares through the trust. Closely held companies can control the voting of the trustee on almost all issues if they so choose.
Stock options: They allow employees to purchase shares in their company at a fixed price when the option is granted for a defined number of years. Option rights are usually subject to vesting. Not all employees can or want to participate. They are relatively simple and inexpensive to install.
401(k) plans: Many companies now match employee contributions to 401(k) plans with company stock. They also allow employees to choose company stock as an investment option.

Setup costs can be high
Of course, ESOPs aren't for every company. For one thing, the costs to set up and administer an ESOP make it prohibitively expensive for companies with 15 or fewer employees. Corey Rosen estimates that it costs about $20,000 to set up such a plan. In addition, the company must be prepared to buy back the stock of employees, which can be a major expense.

In addition to being expensive to set up and run, they're also complicated to run, another reason why extremely small firms should steer clear of them. For example, since their stocks are not traded on a public exchange such as NASDAQ, privately held firms must have their companies valued by an independent firm so a fair stock price can be set. In addition, a trustee must be appointed to oversee the trust.

Finally, some business owners just don't like employees as stockholders. "Especially for the business that has been in the family for 30 or 40 years, there's a perception of a loss of control, and the business owners don't like that," says Patterson of Horty & Horty.

A small business owner who is interested in an ESOP should first explore the feasibility. If the owner decides to go ahead, the next step should be to hire an outside firm to conduct a valuation. Provided that the feasibility study and the valuation give a green light to the ESOP, the owner will next have to hire an ESOP attorney to prepare and file the necessary documents with the Internal Revenue Service.

In addition, the company will need to obtain funding for the plan. Potential sources include banks and tapping the company's existing retirement benefit plan. Finally, the company will need to set up a process to operate the plan and appoint a trustee.

Are ESOPs for every business? Of course not. But there's a happy ending to an ESOP fable for most privately held companies that are seeking to enjoin their employees to work as partners and raise some capital in the process. If it's done for the right reasons and by a company of sufficient girth, an ESOP can be a valuable tool.

Jenny C. McCune is a contributing editor based in Montana
To comment on this story, please e-mail the editors

-- Posted: Feb. 18, 2000

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