How small is too small for an Employee Stock Ownership Plan?

Employees are more productive if they own a piece of the company. That’s the theory, anyway, behind Employee Stock Ownership Plans (ESOPs). According to Rutgers University researchers, ESOPs do appear to increase sales, employment, and sales per employee by about 2.3 percent to 2.4 percent per year over what would have been expected absent an ESOP.

ESOPs are often confused with stock option plans, which grant employees the right to buy company stock at a specified price during a specified period once the option has vested. And ESOPs are also confused with employee stock purchase plans, which give employees the chance to buy stock outright.

An ESOP, in contrast, is a type of tax-qualified employee benefit plan in which most or all of the assets are invested in stock of the employer. Like profit-sharing and 401(k) plans, which are governed by many of the same laws, an ESOP generally must include at least all full-time employees meeting certain age and service requirements. Employees gradually vest in their accounts and receive their benefits when they leave the company (although there may be distributions prior to that).

Employees do not actually buy shares in an ESOP. Instead, the company contributes its own shares to the plan, contributes cash to buy its own stock (often from an existing owner), or, most commonly, has the plan borrow money to buy stock, with the company repaying the loan. All of these uses have significant tax benefits for the company, the employees and the sellers.

Is my company too small?

Sounds great, but is your company too small to have an ESOP? As a rule of thumb, ESOPs work best for companies with more than 20 employees. However with a little back-of-the-envelope calculating can give you a much better idea, regardless of your company’s size, according to analysts with The National Center for Employee Ownership.

There are some basic guidelines that can help you determine when an ESOP is worthwhile. First, of course, you need to know how much an ESOP will cost. There are several components of cost that can vary widely: preparing plan documents and government filings, obtaining a valuation, administration, and, in a leveraged ESOP, loan commitment fees, legal fees for the lender’s counsel and loan documents, and possibly financial consulting for structuring the transaction.

The cost of drawing up the plan documents and government filings is generally not as much as you might think it will be. In a small company transaction, legal fees of $10,000 to $20,000 are typical. These costs will be somewhat lower if you come well prepared, already understanding the basics of ESOP rules and knowing what you want your plan to do. Most ESOP attorneys have plan documents already drawn up. Their fees are more a function of the time they spend with you figuring out what the document should include.

Valuation normally will carry fees in the same range for smaller companies, assuming that there is only one class of stock in the company and no unusual complicating elements. Repeat annual valuations should be about half this fee. It may be possible to obtain an even lower charge in some cases, but do not cut costs by hiring people who do not normally do ESOP work.

Plan administration costs — keeping records, filing reports, sending plan account statements, etc. — depend on the number of employees. There are certain fixed costs, however, so there are some economies of scale for larger firms. A firm of 20 employees might reasonably expect to pay around $2,000 per year as a base cost, plus $30 to $60 per employee.

Assessing Costs vs. Benefits

Yes, setting up an ESOP will cost you, but a plan brings a number of advantages for your company. In addition to employee satisfaction and productivity, ESOPs allow companies to:

• Borrow money at a lower after-tax cost: ESOPs are unique among benefit plans in their ability to borrow money. The ESOP borrows cash, which it uses to buy company shares or shares of existing owners. The company then makes tax-deductible contributions to the ESOP to repay the loan, meaning both principal and interest are deductible.
• Create an additional employee benefit: Companies can simply issue new or treasury shares to an ESOP, deducting their value for up to 25 percent of covered pay from taxable income. Rather than matching employee savings with cash, the company will match them with stock from an ESOP, often at a higher matching level.
• Purchase shares of a departing owner: Owners of privately held companies can use an ESOP to create a ready market for their shares.

Like all plans of this kind, ESOPs do have limits. ESOPs, for example, can’t be applied to partnerships and most professional corporations (although S corporations can use them). Plus, private companies must repurchase shares of departing employees, and this can become a major expense. Finally, ESOPs will improve corporate performance only if combined with opportunities for employees to participate in decisions affecting their work.

Despite the costs, ESOPs have advantages for employers. For more information on setting up an ESOP, please contact us. Remember, Thoits is proud to be 100% employee owned with our own ESOP!