Many of us have been ingrained since birth with the idea that being your own boss and determining your own destiny is a fundamental part of achieving the American Dream. After all, taking risks and being entrepreneurial can yield great rewards.
Of course, building a business is easier said than done. Furthermore, even the most prosperous ventures have some disadvantages. Chief among them is that most small business owners have a lion's share of their personal net worth tied up in the value of the companies they have built -- possibly creating considerable risk in both the short (business failure) and long term (liquidation).
Indeed, while the U.S. economy has improved in recent years, the number of willing and able buyers of small to midsize businesses has cratered dramatically since the halcyon days nearly a decade ago, just before the financial crisis. As a result, a number of otherwise successful entrepreneurs looking to sell their businesses have been put in a precarious spot.
A capable and conscientious advisor, however, can support small business clients by helping eligible entrepreneurs establish an Employee Stock Ownership Plan, often referred to as an ESOP -- essentially a trust fund set up by the owner, who then distributes new shares of company stock to their own employees.
Prime candidates for ESOPs have company payrolls of $800,000 or more, a five-year history of profit, a market value of at least $3 million, and must be filed with the IRS as either sub chapter S or C corporations. And as with any venture, its important for advisors to perform the proper due diligence, consulting with a plan advisor to ensure the most advantaged program possible for the widest possible net of employees -- not to mention to the small business owner.
Over the years, ESOPs have proven especially adept at generating income and monetizing value for the business owner in the short term, while also helping to nurture truly institutional, resilient enterprises that are built to last the test of time. Beyond the surface advantages, though, additional benefits of ESOPs encompass the following:
- Advantageous tax implications: There are numerous tax benefits for both the owner and the employees. Sellers, for instance, can roll sale proceeds into an IRA or a host of qualified publicly traded securities, perhaps providing a vehicle to avoid significant tax liability. Companies, for their part, are able to deduct contributions to the ESOP trust fund from their corporate income taxes. Therefore, if 70% of the firm's workforce participates, they could wipe out 70% of the corporate income tax bill, enhancing cash flow for business investment considerably.
- More stable, efficient workplace: Employees that have a financial stake in a business are more loyal and work harder to achieve firm-wide success, which creates a culture based on collaboration and teamwork.
- Confidence for departing owners: Historically, a well-conceived ESOP has been shown to significantly increase the chances that the business will have a buyer -- and perhaps most importantly in light of the current environment, one that will pay market value (determined by a third-party appraiser). Owners can train, develop and prepare their successors, while still generating income and preserving the internal culture of the firm.
By the same token, there are a few pitfalls associated with setting up an ESOP that advisors should keep in mind:
- Share dilution and volatility: When new shares are issued within a company plan, the existing shares immediately lose value, since the total value of the ESOP remains unchanged -- although for profitable businesses with a history of growth, the devaluation is sometimes offset by future gains. Also, because the value of the shares is based entirely on the fortunes of the company, they are extremely volatile investments. A well-diversified IRA, 401(k) or other employer-sponsored retirement plan can serve a suitable counterbalance.
- High administration fees: ESOP set-up costs are $50,000 or more, depending on the size of the business, with yearly maintenance fees exceeding $10,000.
- Not all small businesses are eligible: As mentioned above, only sub chapter C and S corporations are eligible. Professional corporations, partnerships, LLCs and sole proprietorships are not.
While ESOPs should not be considered a panacea for all small business owners, used effectively in the right circumstances they can be an effective vehicle in driving productivity and growth.
Meanwhile, it is becoming apparent that advisors looking to be all things to all people will likely have trouble adapting to the emerging trends within the financial service space. Advisors, therefore, that can add a specialized set of services to their clients -- such as becoming ESOP experts -- will offer tremendous value relative to their competition.
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