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An Employee Stock Ownership Plan (ESOP)is a tool business owners use to achieve threecommon Exit Objectives:1.To leave the business soon;2.To leave the business with cashadequate for financial security; and3.To leave the business to employees.Let’s look at the case of Steve Victoria, soleowner of Victoria Engineering and Consulting,Inc. (VECI).VECI was a 35-person firm with annualrevenues of $5 million and annual cash flow of $500,000. Steve explored the sale of hiscompany to an outside third party, but, after hisbusiness broker’s investigation, it appearedthat a cash sale was unlikely.Steve’s second choice — to sell VECI to hisemployees — was problematic because heknew they lacked the ability (and, perhaps, thewillingness) to obtain meaningful financing.Steve was unwilling to leave VECI in the handsof his employees — no matter how capable of running it they might be — without the majorityof the company’s value converted to cash andstowed safely in his pockets. There seemed tobe no way out. He was stuck in his business.Steve’s only exit appeared to be to diminish hisinvolvement gradually in the hope that VECIcould continue to distribute earnings to him.Then Steve read an article in an airline travelmagazine that presented an appealingalternative: He could cash out for fair value, hisemployees could own VECI, and — thefrosting on the cake — he would pay notaxes on the sale. The article painted a picturefar too good to be true, but he deemed it wortha phone call to his crusty old law firm. ThisWhite Paper describes “the rest of the story.”
Employee Stock Ownership Plan
ESOPs have received a lot of favorable presslately. It is almost as if an ESOP is the modern-day equivalent of a diet pill that lets folks eat allthey want and still lose weight.ESOPs are touted as allowing businessowners to cash out at fair market value fromtheir businesses, pay no taxes on the sale and,in the process, transfer their companies to their employees. To separate truth from fiction - or reality from hype - business owners need toask the following questions:What is an ESOP?How does an ESOP buyout work?What company characteristics areneeded to make an ESOP work well?What are the disadvantages to an owner in selling to an ESOP?What are the advantages to an owner of selling to an ESOP?This White Paper explores each question andwill help you make sense of the hype and of the confusing technical requirementssurrounding ESOPs.
WHAT IS AN ESOP?
ESOPs are qualified retirement plans, typicallyprofit sharing plans, which must invest primarilyin the stock of the sponsoring employer (inyour case, the sponsoring employer isyour business). As such, ESOPs must
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ESOP Opportunities White Paper
 
follow all requirements of governing law,including:All full-time employees eventuallyparticipate in the plan.Each participant is allocated a share of the plan assets in proportion tocompensation.Full vesting of benefits cannot exceedsix years from date of participation.Upon termination of employment, theplan must give the participant the rightto receive his or her account balance incash over five years.Contributions to the plan by thecompany are tax deductible and theplan does not pay income tax on incomeit earns. Eventually, participants pay anincome tax when they terminateemployment and receive a cashdistribution from the ESOP (unlessrolled over into an IRA).The chief difference between an ESOPand a regular profit sharing plan is thatESOPs must invest primarily in thestock of the company sponsoring theplan.An ESOP can receive contributions of stock or cash from the company. If itreceives cash, that cash can be used topurchase stock from the owner of thecompany.An ESOP may borrow funds (a“Leveraged ESOP”) to acquire stockfrom the owner of the company.
HOW DOES AN ESOP BUYOUT WORK?
As the chart below illustrates, in itssimplest form, an ESOP buyouttransaction contains the following parties:1.The company that contributes cash to itsESOP.2.The ESOP that uses the tax deductiblecontributions to acquire the owner’sstock.3.The owner who transfers his stock to theESOP in return for cash. If thistransaction meets certain qualifications,the cash that the owner receives is nottaxed to him. In this scenario availablecash flow of the company is contributedon a tax-deductible basis to an ESOPwhich pays that cash to an owner whomay be able to receive payment withoutpaying any taxes provided certainrequirements are met.4.A bank. Since most owners want asmuch cash up front as possible whenthey sell their stock, a financing sourceis usually required which will loanmoney to the ESOP that in turn uses theloan proceeds to acquire the owner’sstock.5.The loan is repaid from the company’sfuture contributions to the ESOP or dividend payments from the stockowned by the ESOP.At this point, the employees/participants havebecome, at least indirectly, the new owners of the company. Their interests will need to beprotected throughout the transaction.
WHAT COMPANY CHARACTERISTICS ARENEEDED TO MAKE ESOPS WORK WELL?
ESOPs are not for every business. To besuccessful a company should have the
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following characteristics:Strong cash flow;Good management team to carry onafter the owner has left;Little or no permanent debt;Relatively large payroll base (but notalways);Alignment of shareholder and employeeinterests; andAdequate capitalization to sustain futurecompany growth.If your business lacks any of thesecharacteristics, especially the first three, it isunlikely that an ESOP is the best path for you.
WHAT ARE THE DISADVANTAGES TO ANOWNER OF SELLING TO AN ESOP?Cost
ESOPs are costly to establish and relativelycostly to maintain over the years; in manyrespects the sale of stock to an ESOP is morecomplex and almost as expensive as a sale toan outside third party. The fees for a LeveragedESOP buyout of an owner range, from $25,000to $100,000. In addition, to establish an ESOP,at least one arms-length, third party appraisalis needed (at a cost of $10,000 to $20,000, or more). An annual update to the appraisal isalso required at a cost of several thousanddollars.
Fiduciary Responsibilities
The fiduciary responsibility requirements of theEmployee Retirement Income Security Act of 1974 (ERISA) are significant. Thefiduciaries of an ESOP (which typicallyinclude the company, the trustee and theindividual members of a committee appointedto administer the ESOP) must be certain thatthe ESOP transaction is undertaken for thebenefit of the participants and their beneficiaries. Furthermore, ESOP fiduciariesshould hire independent legal and financialadvisors to advise them on the structure andappropriateness of the purchase of stock fromthe owner. Owners can and should minimizetheir fiduciary risk by letting others serve asESOP trustees and by making certain thatthose trustees exercise independent judgmentand seek advice from experienced advisors.
Repurchase Requirements
When a participant terminates employment, thecompany (or the ESOP) must repurchase thedeparting employee’s stock over a five-year period. This “repurchase liability” will eventuallybe significant as employees retire and leavethe company. To fund this liability the ESOPmust receive additional cash contributions fromthe company or the company must buy backthe stock directly from the departingparticipant.
Pre-Funding
Pre-funding of an ESOP by the company isnormally required. A bank is not going to lend100 percent of the purchase price of anowner’s stock. With a strong balance sheet,banks might lend 60 to 70 percent of thepurchase price. Consequently, companiesoften pre-fund the ESOP by makingcontributions during the one to three yearsbefore the intended stock transaction.This pre-funding serves as the ESOP’s
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