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Why an ESOP Probably Isn’t Right for You

by | April 23, 2024 | Exit Planning, Education, ESOP's

Reading Time: 4 minutes

If you’re like many business owners who’ve been running their company for 10, 20, or 30 years, you might be feeling a time crunch. You’ve likely seen peers struggle to sell their business, and you’ve started wondering if time’s running out for you too. This rush has many owners eyeing Employee Stock Ownership Plans (ESOPs) as a quick way to head for the door.

Owners gravitate towards ESOPs for several main reasons, like the tax benefits, or the allure of offering employees a stake in the company’s future. Others just want a simple way to retire or shift their focus, allowing them to pass on their legacy to those who helped build it.

However, most owners heading toward an ESOP are driven there by a lack of time or lack of information, and based on what we see in the market, they’re missing out on much better options. Let’s clear the fog around several misconceptions that might make ESOPs appear more attractive than they truly are.

Employees tend to prefer cash over equity

We all like the idea of our employees owning a piece of the pie, but the truth is, many would rather just have the cash. Equity, or shares in the company, can be complicated and risky.

Employees might not want the worry of stock values or the wait for long-term benefits—they might prefer their rewards in cold, hard cash. This mismatch can lead to disappointment if employees aren’t as thrilled about becoming owners as the boss thought they’d be.

Plus, with employees changing jobs more often, you’ve got less of a stable workforce as you have historically. A lot of folks are going to their employees and asking if they’d like to own the business, and the response surprises them: “No, I’m only going to work here for another two or three years, then I want to join the next dotcom or venture deal, etc.” This kind of ownership isn’t as appealing as it once was.

Owners underestimate ESOP administrative costs

Setting up an ESOP isn’t as straightforward as it might seem, in part because there are all sorts of legal and administrative hoops to jump through. These admin costs can climb much higher than many business owners expect (often $200k-$300k per year), nibbling away at the financial benefits they were hoping for.

It’s kind of like buying a fixer-upper home thinking you’ll save money — the renovation bills start piling up, and before you know it, you’re not saving nearly as much as you thought you would.

The tax benefits don’t help your numbers in the end

ESOPs are frequently marketed for their tax benefits, which can indeed be significant—such as deferral of capital gains taxes for sellers and tax-deductible contributions for the company.

However, these benefits need to be weighed against the total financial picture. For instance, businesses are often valued lower in an ESOP than they might be in a traditional sale. When the dust settles, the financial outcome of an ESOP can closely mirror that of a conventional sale, once you account for the lower valuation and the tax implications.

Owners might also face unexpected complications, like ensuring the business generates enough profit to cover the contributions to the ESOP, which can further complicate financial planning.

ESOPs aren’t as simple as they sound

Owners approaching retirement or career pivots often turn to ESOPs as a simple way to step back from the business, usually because they feel they don’t have enough time to plan for a successful exit. But you still need to be aware of the fact that ESOPs can be more complicated than expected:

  • Trust and control: An ESOP requires placing a significant amount of trust in a third party or a trustee, which can be a bitter pill for entrepreneurs accustomed to steering the ship themselves.
  • Financing the ESOP: Whether borrowing from a bank or dipping into personal liquidity, financing an ESOP can introduce debt and financial strain on the business.
  • Delayed seller payouts: Contrary to expectations of a quick exit, sellers may find themselves waiting 5-10 years to fully realize the financial benefits of the ESOP.

ESOPs are not the only option

In today’s market, there is a buyer for almost any type of business. Yet business owners sometimes feel cornered into thinking ESOPs are their sole exit or succession strategy, often because they didn’t explore their options or prepare for a sale.

If you find yourself thinking “I’m not sellable, nobody would be interested, so I might as well sell it to my employees,” then you’re setting yourself up for a substantial opportunity cost.

This often happens because owners aren’t aware of their options. Think of it like selling your house; you wouldn’t just offer it to your relatives without checking out the market first, right?

Even just looking at what an outside investor can provide, you have all kinds of options that give you difference balances of control and liquidity, and that’s before you look at different forms of co-ownership, gifts to family, or trusts — and that’s just the tip of the iceberg. We wrote about 30 options alone right here.

Similarly, not everyone understands enough about how businesses can be structured for sale — your business is much more sellable than you probably think.

There are better ways to reward your employees (and yourself) than with an ESOP

If managed well, an ESOP can lead to greater employee engagement if they feel like their owners and have “ownership thinking.” But there are other ways to engage employees and incentivize them (as many private equity firms have realized), such as management incentive pools and direct equity instead of an ESOP structure.

There are some great hybrid tools out there that almost give you similar bang for your buck as an ESOP, sometimes more, and have the added perk that  you get your liquidity quicker.

If you do decide to go the ESOP route, remember you can still sell the business later.  Let’s say you decide you want the liquidity faster than a 10 year run rate — an ESOP doesn’t necessarily mean you have to be in ESOP forever.  The difference is whatever shares your employees now own, they would participate in that exit as well, and receive that payout.

For owners who want to reward employees (and drive over-market results), work with a buyer that will spread that love (in the form of real equity and incentives) to a larger swath of employees.

What are you looking for in your exit?

Ask yourself what you want to achieve — do you mainly want to give employees a benefit, or is your focus more about creating liquidity? If liquidity is your primary goal, you’ve got a full toolkit  of options, and ESOP shouldn’t be anywhere near the top of the list.

To find out more about planning your exit, book a call with a senior professional at Merit who can help you determine the best path forward. Our team is composed of seasoned investment bankers and advisors who not only understand the intricacies of financial markets but also have a deep empathy for the entrepreneurs and business owners we serve.

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