Sometimes business owners who are ready to retire decide to sell their company to the employees who helped make it a success.
One way that happens is through an employee stock ownership plan, or ESOP.
Steve Eide, an attorney with Gray Plant Mooty in Minneapolis, has advised businesses on how to set up and run ESOPs, a process that can involve changes in the corporate structure.
His clients include Border States Electric, a Fargo-based electrical supplier, and Walman Optical Co., based in Minneapolis, both ESOPs.
He talked recently to the Star Tribune.
Q: If a business owner wants to sell to employees using an ESOP, must they come up with money to buy the company?
A: No. The employees are not paying anything to acquire an interest in the company. The ESOP usually borrows the funds to buy the stock. The debt is paid off over time with contributions that the company makes to the ESOP each year.
Q: Business owners might get more money selling to a competitor. Why sell to an ESOP instead?
A: They may like the flexibility of selling to an ESOP, where they can sell maybe 30-40 percent of their stock and stay involved with the company, and five or 10 years later sell the rest. There’s a greater chance all the employees will retain their jobs and the business will remain in the community where it was founded.
Q: In an ESOP, what control do employees have?
A: Employees don’t have direct control over who is going to manage the company. The governance of an ESOP company is similar to any other privately held company. The difference is that ESOP shares are held by the trustee of the plan, who is subject to federal pension laws and must act in the best interest of the participants when voting for the board of directors, for example. Employees do have direct voting rights on major corporate events like a merger or selling off assets of the company.
Q: What happens when a business owner is thinking of setting up an ESOP?
A: There is an education process at the beginning to make sure the owner understands what an ESOP is and the legal requirements that come with it. Then we go through a feasibility analysis where we determine if the company is a suitable candidate to be an ESOP company.
Q: What factors are favorable to creating an ESOP?
A: You’d like to see strong cash flow, a solid management succession plan and the capacity for more borrowing if necessary.
Q: Who are typically chosen as trustees?
A: There are a number of institutional trust companies that have a specialty acting as an ESOP trustee. At smaller companies, sometimes an insider other than the selling shareholder will act as the trustee.
Q: What do the employees own and what happens when they leave the company or retire?
A: They own a beneficial interest in shares of stock of the company, which means they receive all the economic benefits of ownership, such as appreciation in value and any dividends that are paid. But they don’t have the ability to sell those shares whenever they want. When they leave the company, the rules require that their stock be converted to cash by the ESOP, which would issue them a check, or they might receive the stock, in which case the company has an obligation to buy the stock and pay them cash.
Q: What changes have you seen when companies become employee-owned?
A: Often there is a significant cultural shift, and many ESOP companies work very creatively to generate that shift. What they are trying to get across to the employees is that now they have shared rewards as well as shared responsibilities, and they try to create a more collaborative, participative working environment where the employees feel empowered to make decisions that will improve the bottom line for everybody. I have seen studies that show employee-owned companies generally have higher productivity and operate more profitably than their peers.
Q: Do employees at an ESOP face additional taxes before they retire?
A: No. From the employee’s perspective the tax obligations on an ESOP benefit payment are the same as they are for a 401(k) participant. It is ordinary income unless you roll it into an IRA. There is a 10 percent penalty if you receive it before you are 59½ unless an exception applies. If an ESOP participant receives stock from the plan in a lump-sum distribution and the stock has gone up in value, that appreciation in value may be taxable as a capital gain.
Q: What are the highest payouts you’ve seen as people retired from these companies?
A: I have seen payouts greater than $2 million, and I have seen accounts of people who are still working that are even higher than that.