Why, How & When To Join Employee Ownership’s Big Mo

It’s certainly becoming the Decade of Employee Ownership. The attention toward employee stock ownership plans, or ESOPs, and related avenues such as employee ownership trusts continues to intensify. Private equity firms such as KKR and Blackstone are sharing the growth in the value of their portfolio companies with workers across the board. And Congress and more states have taken notice of EO’s benefits that align worker and company incentives, with years of research proving its efficacy, including greater top- and bottom-line financial growth.

Sounds amazing, and it’s hard to know where to begin. Yes, looking at all the alternatives can be overwhelming to business owners seeking a succession plan and companies trying to reward workers by augmenting employee engagement, driving culture and performance, and attracting and retaining talent.

Know this: the broad range of opportunities put together, have the power to transform our economy as they continue to become more widely adopted.

Back when I started as an advisor 30-plus years ago, so-called “plain vanilla” ESOPs were the primary route to consider. In contrast, today’s choices include a wide variety of ESOPs, partnering with private equity firms, employee ownership trusts (EOT), stock-based profit sharing, and creative broad-based short- and long-term bonus programs.

The right strategy exists for you. Patience and understanding can cut through the justifiable confusion. To help clear up this perplexity and highlight the merits of each type of plan, consider this primer. Use the distinct benefits that different plans afford you, your employees and your corporate performance to guide your decision about where EO aligns with your aspirations.

First, consider the ESOP. The tried-and-true structure has existed in some form since the 1950s and is the only tax-qualified U.S. retirement plan that can borrow money. ESOPs can take many forms, which highlight the star attribute of flexibility of a well-designed plan, and they gain attention from the associated tax benefits for both sellers and companies. Plan types include:

• 100% ESOP: These are fully employee-owned companies with maximum tax benefits that can also drive a high-performing culture. Moving from a partial to a 100% ESOP increases the optionality of executing different corporate strategies.
• Partial ESOP: As the name implies, it is a sale of less than 100% of a company’s shares to an ESOP trust. This offers flexibility for owners who may want to diversify part of their business wealth or who aren’t the sole owner and want to sell their ownership stake while avoiding capital gains taxes. Also, owners often are motivated by mixed shareholder objectives (as some want to sell and some want to stay), partial diversification, and increased employee benefits. NOTE: Partial ESOPs have the opportunity to drive culture and engagement as 100% ESOPs do.
• Contributory ESOPs: In these plans, contributions of cash or stock directly from the employer fund the ESOP. Employees benefit directly from the company’s success – which helps retain and recruit talented employees – and employer contributions may also provide tax deductions.
• C or S Corporation: Both can employ ESOPs. C corporations enjoy tremendous ESOP tax advantages, including the ability for a selling shareholder to permanently defer capital gains on sale proceeds (often called “Section 1042”). Further, an ESOP is a tax-exempt shareholder of an S-Corporation, enabling a company to eliminate federal taxes, retain my cash, payoff selling shareholders and invest in corporate growth. NOTE: these significant tax benefits can tip the scales toward an ESOP sale over a third-party sale to a strategic buyer.

Now, consider EOTs. While the first EOT was established in Washington state over 125 years ago, they re-emerged in the United Kingdom in the 1990s and have since gained traction across the U.S. – from Massachusetts and North Carolina to Colorado and California. EOTs are viewed as a forward-thinking model for business succession and long-term sustainability.

In effect, EOTs are profit-sharing plans that own some or all of a company’s shares for their employees’ benefit. While they are simpler and less expensive to create than an ESOP, they don’t enjoy as many tax benefits. Employee ownership trust participants receive their profit share (think of it as a bonus, W2 ordinary income) rather than through distributions of shares to a retirement account as in ESOPs.

As for private equity, after decades of overlooking ESOPs, PE firms have recently become interested in them, recognizing their value as a corporate finance tool, effectiveness in employee engagement, a potential exit strategy for their portfolio companies, investment opportunities to help existing ESOP companies grow, and more.

Since then, institutional investors have come to view employee ownership as a strategic approach that can improve company performance and employee engagement. We are excited about this growth in offering broad-based profit sharing and wealth building strategies to workers who would otherwise have had no chance at economic participation in the growth of the companies they work for.

Illustrating the EO momentum, Expanding ESOPs, a nonprofit coalition of over 80 organizations, is working to dramatically scale the adoption of ESOPs among larger companies, with a particular focus on the partial C-Corp ESOP model to exponentially increase the number of workers who are owners, creating wealth and retirement security for an under-saved population.

Another non-profit that helps companies implement employee ownership models is Ownership Works. It often assists companies that, for a variety of reasons, would be unlikely and unable to form an ESOP. Many private business owners prefer to sell to PE. O.W. bridges that opportunity of broad-based wealth sharing by facilitating broad-based ownership into dozens of private equity acquisitions. It works with PE firms along with public companies and family-owned businesses in applying employee ownership models that align owners’ and employees’ interests. A win-win in my book.

Whew! That’d a lot to absorb, and we hope this primer helps. Through our decades of work as well as our proprietary research involving 310 company founders and C-suite executives, we know the challenges of getting your arms around the multifaceted subject, but also the value that comes from picking the right structure.

These business owners and leaders tell us that networking with their peers and their advisers’ expertise help them grasp the intricacies of employee ownership, and ESOPs in particular. That knowledge led them to overwhelmingly agree that employee ownership is a winning strategy. The benefits of preserving their company’s legacy, improving their financial and operational performance, significant tax advantages including gift and estate planning opportunities, all while delivering their employees meaningfully better jobs, incentives and wealth creation. As I said above: win-win.