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ESOP Expert: Employee Ownership Is a Capitalist Tool

Talk about employee ownership, and some think socialism. Anything but, says Darwin Hanson, an expert in compensation and employee stock ownership plans. 
Ask Darwin Hanson for the definition of an Employee Stock Ownership Plan, and the answer has nothing to do with starry-eyed social motives. An ESOP is a “retirement and tax strategy for both the employer and the employee. It can also be a very good businesses strategy because employee-owned companies generally outperform traditional companies.”
Darwin Hanson is CEO of Talent Management Evolution, a Brainerd, MN-based talent management software and compensation company, and an expert in ESOPs. 
To consider creating an ESOP, a company must be structured as an S corporation or C corporation, because it must have shares available to sell to employees, unlike a Limited Liability Corporation (LLC) or partnerships, whose ownership is based on membership percentages.

From the employee’s point of view, the fundamental distinguishing factor between an ESOP and an Employee Stock Purchase Plan (ESPP) is that employees do not purchase the shares. They do not have to do anything but remain on the job for the time necessary to vest in their shares, which are generally allocated as a percentage of an employee’s salary to the total payroll. Some organizations include tenure in the calculation for recognition of longevity.

The Criteria for Success 

TMEAn ESOP has many advantages for owners, Hanson says, but it’s not for everyone. It is designed for owners who wish to both motivate employees as well as establish an exit strategy at a fair market valuation. This can be accomplished over time or quickly and the current owners can relinquish control or design the plan that allows them to remain in control for as long as they would like. One critical factor in determining whether to create an ESOP is the owner’s conviction that the company’s current management and employees can and will continue to successfully run the company, even if the current owner is no longer an active member of the management team.

Under an ESOP, owners can sell any desired percentage of the company at any time to employees, with their shares paid for out of cash flow based on a third-party company valuation, he explains. The owner pays no tax on the sale provided the money is reinvested in some other form of equity or qualified investment within one year, so that the tax on the sale is deferred until a liquidity event. Under ordinary circumstances, long-term capital gains are taxable at a rate of up to 20% under current tax law, depending on the amount.

Hanson says ESOPs are for established companies run by owners as a strategy to optimize the engagement of employees while looking for a dependable, tax-friendly exit strategy. ESOPs generally are for owners who either do not wish to pursue or do not have a company suitable for a public offering or who wish to have a liquidity event without giving up control to a private equity or other firm.
ESOPs generally are not for startups, he emphasizes, because setting up and running an ESOP is cost prohibitive if there is under 20 employees and profits under $1 million per year. The company must have the cash on hand to pay vested employees who resign without depriving the company of necessary cash flow, and should not be in a position in which employee payouts undermine the company’s ability to effectively compete. In addition, setting up an ESOP can cost $75,000 or more in legal and accounting fees and at least $25,000 per year to administer it.
In a leveraged ESOP, the company can borrow the money and then lend it to the ESOP in order to pay the owner(s) for the sale of their stock at the then fair market value. The owner can receive all or a portion of their share value from the ESOP. The company then pays the maintenance on the loan out of cash flow. Another non-cash option enables owners to simply grant new stock to employees without any immediate cash outlay by the company, which does however dilute their ownership percentage.

Considerable Flexibility Provided 

ESOP plans afford owners considerable flexibility within certain restrictions. Employees must be able to vest in their shares within six years (three years if cliff vesting is used), which means that when they leave, they can cash out at fair market value. This allows the owner to establish a vesting schedule that encourages employee retention. In addition, the owner(s) can take as long as they like to cash out and are not prohibited from changing their mind and selling their remaining shares. ESOP participants, however, who want to cash out must give the ESOP the right of first refusal to their shares. Employees do not have direct voting rights. A management committee is set up to direct the rights of the ESOP participants, including voting rights. The owner can appoint the management committee composed of hand-chosen members along with at least one employee representative, so the owner can choose to retain control. That said, Hanson emphasizes that the best-run ESOPs involve employees in key management decisions, “because that’s the entire point of an ESOP: to have employees actively involved in the welfare of the organization.”

He explains, “When ESOPs are properly run, employees feel a higher level of pride in the organization and have a clearer connection between what they do for the company and its success. This leads to higher productivity and quality, and a greater willingness to refer others to the company, confirmed by multiple research studies.”
For More Information
Darwin Hanson, CEO
Talent Management Evolution

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