Reading time: 4 minutes
As Baby Boomers continue to retire and transition ownership in their companies either to family members or outside buyers, another type of transaction is emerging as an option – an employee stock ownership plan, or ESOP.
In the construction industry, where the market for third-party buyers can be limited, an ESOP may provide a strong transition option for a seller with no family members interested in owning the company and who doesn’t want to sell to a private equity or venture capital entity.
While ESOP formation has remained flat for the past five years, research shows that interest in ESOPs rises as business owners become more educated about their benefits. Moreover, today’s high interest rates may drive more interest in ESOP formation as valuations are discounted, making sales of companies to external buyers less attractive.
What is an ESOP?
An ESOP is a qualified retirement plan that gives workers ownership interest in the company in the form of shares of stock. ESOPs are governed by the Employee Retirement Income Security Act (ERISA), which also governs other retirement plans like 401(k) plans.
When a business owner decides to utilize an ESOP for business succession, the first step is the creation of a trust that holds the assets of the ESOP. The purchase price is negotiated and bank financing is obtained to redeem the shareholder stock and subsequently sell it from the company to the trust under a seller finance note between the company and the trust.
As the financing debt is paid down, shares in the company are transferred to the trust and apportioned to each employee based on compensation. Periodic allocations of shares enable employees to build equity in the company over time.
Various tax benefits exist for companies that sponsor ESOPs. For instance, if a C Corporation sells a portion of the company to an ESOP and observes certain rules governing investments, any realized gain to the owner is tax free.
Although ESOPs provide retirement benefits to participants, companies usually also have a 401(k) plan running alongside. The contributions to the ESOP for each employee are made by the company, not the individual. So, individual retirement contributions are made separately by employees to their 401(k) plans.
One significant advantage of ESOPs is the ability to align the company’s interests with those of the employees. In other words, when employees have skin in the game as owners, they think more like owners and take a more active, insightful role in the operations, knowing they will reap the financial benefits down the road.
There are also tax advantages for companies and for the selling owners. Sales to ESOPS generally are stock sales, giving the owner capital gain treatment for the transaction. Moreover, an S Corporation that is 100% owned by an ESOP pays no income taxes, and a C Corporation can effectively deduct the loan payments made on the ESOP bank financing.
ESOPs can also be advantageous for recruiting and retaining talent, serving as a strong incentive to stay with the company long enough to benefit from stock ownership.
Not every company is a good candidate for forming an ESOP, and sellers should consider the following factors when seeking guidance:
- Are strong, experienced managers in place who will stay with the company?
- Are profits consistent?
- How flexible can the seller be on repayment terms?
- Does the ESOP model align with the company’s culture?
Construction Company ESOPs and Surety Coverage
Surety companies place a keen focus on the management of a construction company when evaluating it for bonding. When an ESOP is in place, the surety company will likely want to know how the ESOP is structured and the extent to which the selling shareholder is still involved in management.
ESOP construction companies used to have a difficult time getting surety bonding, but as the prevalence of ESOPs has grown and the surety experience has been largely positive, the difficulty has eased. Sureties have more experience and confidence in dealing with ESOPs today.
There are challenges to setting up an ESOP, however. The costs of maintaining an ESOP are sometimes daunting to smaller businesses, contributing to the significant drop-off of companies under 50 employees that have ESOP plans. Depending on the size of your company, set up and first-year operation of an ESOP can cost anywhere from $80,000 to $250,000. Expenses include fees for legal and accounting services, as well as consulting services. Annual costs thereafter may be $20,000 to $30,000, including the cost of an annual audit, which is a legal requirement.
The ESOP operating entity will need an annual audited financial statement prepared for the bank holding the ESOP’s loan and the valuation company.
An ESOP plan audit is conducted as a full-scope audit. During an ESOP audit, the auditor will review:
- The plan’s documentation to ensure that it meets legal requirements and that the plan’s assets are properly valued. The auditor will also examine the company’s financial statements to ensure that the ESOP’s financial transactions are properly recorded and that any related tax implications are appropriately accounted for.
- The company’s procedures for administering the ESOP, including the methods used to allocate shares to employees and the methods used to determine the value of the company’s stock.
- The plan’s communications to employees to ensure that they are clear and accurate.
The goal of an ESOP audit is to provide assurance to the company, plan participants and regulatory authorities that the plan is being managed in compliance with applicable laws and regulations, and that the interests of plan participants are being protected.
One oddity of ESOP finance is the reality of negative equity. Negative equity is a deficit of owners’ equity occurring when the book value of an asset used to secure a loan is less than the outstanding balance on the loan. However, as the ESOP pays down its loan, the shareholder equity equalizes and eventually enters positive territory.
We’re Here to Help
If you have questions about whether an ESOP may be the right exit strategy for your business, JLK Rosenberger can help. For additional information, call us at 949-860-9902, or click here to contact us. We look forward to speaking with you soon.