Great Ideas for your Small Business: Create an Employee Stock-Ownership Plan
When a small business owner wants to cash out or pull some equity out of his or her business, there are several options. One of the best options for both employers and employees is an employee stock- ownership plan, or ESOP.
ESOPs allow business owners to sell company shares to employees at a fair price. ESOPs also provide significant tax benefits for owners while providing retirement benefits for workers. Workers who own shares usually feel more loyal and driven to perform, so productivity increases and, as a result, their stock increases in value. An ESOP can also help finance the expansion of the business, so everyone benefits.
ESOPs work especially well for small, stable companies with fewer than 100 loyal, long-time employees. “The employees get all the economic benefits of being a share- holder without the liabilities,” said Steve Bohn, senior vice president of business advisory services for Merrill Lynch. Merrill Lynch helps finance ESOPs for companies around the country. Bohn, who had twenty-one ESOPs in progress when we spoke, said there are about two hundred to four hundred ESOPs set up every year. They work well for a variety of companies in a wide cross section of industries.
America has about 11,500 employee stock-ownership plans, according to the ESOP Association in Washington, D.C. In a 1995 study by the ESOP Association, 60 percent of member companies said productivity increased after the ESOP was put into place. Of those surveyed, 86 percent said creating the ESOP was a “good decision”; only 2 percent said it was a “bad decision.”
One huge perk for business owners is the ability to deduct both the principal and interest on any loan used to finance an ESOP. “In essence, you are sheltering a bunch of income that you used to pay taxes on,” said Bohn. “You can use the entire distribution tax-free.”
If you are thinking of creating an ESOP, you’ll need a team made up of an attorney, an accountant, and a banker or brokerage to provide the cash to buy the shares. You’ll also need a skilled administrator to keep track of the paperwork and distribute shares when employees quit or retire. Most employees are vested in the plan after five to seven years.
“We were the ideal company for an ESOP,” said Skip Musgraves, chief financial officer for Tesco Williamsen in Salt Lake City, Utah. “It doesn’t work for everybody, but in our case it was a perfect fit.”
The company, which began making covered wagons in the 1890s and now makes truck-mounted heavy equipment, had merged with another equipment maker in the 1980s and soon after hit a sales slump. “Two struggling companies came together, and it was a rough road,” said Musgraves.
In 1994 the company president wanted to liquefy some of his investment and was looking for tax benefits, Musgraves said. Tesco Williamsen did a leveraged ESOP, borrowing under $5 million from its local commercial bank to set up the plan. Every dollar spent paying off the loan is tax deductible, “dollar for dollar,” said Musgraves.
The eighty-five loyal employees each received stock in the company and were fully vested seven years from when the plan was created. “They not only have the money they make in salary but a piece of the action,” said Musgraves.
He said it is important to explain the ESOP process to employees to make sure they fully understand the benefits. They also need to know it doesn’t cost them anything, because only the company invests in the plan. “Make sure your employees understand what a wonderful, rich benefit it is,” said Musgraves.