Millions of Baby Boomers voluntarily left the labor force in 2020 at a more accelerated pace than in previous years, according to the Pew Research Center.
Departing Boomers could afford to retire because they had the means to put the 8-to-5 grind in their rearview mirror and pursue personal passions. Many had the means to retire because they prospered as owners of thriving businesses.
But there’s a dilemma these owners are also confronting: how to keep operations going long after they are gone.
What I mean by that is a reference to owners who built mom-and-pops to the point they think of their employees as family. Their businesses served as community pillars, creating jobs, providing services, adding to the tax base and supporting charitable causes. That legacy could be vulnerable if they closed or sold.
Enter the Employee Stock Ownership Plan (ESOP), a complex, compassionate tool that’s growing in interest. An ESOP is an exit strategy that’s as much about preserving a company’s culture and values as it is keeping its operations financially viable.
Nationally, there are over 6,000 ESOPs covering 14.2 million people, according to the National Center for Employee Ownership. ESOPs are a growth market for those who feel increasing pressure to find an exit plan among limited options.
ESOPs, in my opinion, are a great solution. It’s why, over 30 years ago, I personally switched from focusing on Defined Benefit retirement plans into tax-advantaged, culture-preserving ESOPs. For the business owner seeking to sell, rather than just list with a broker, he or she can consider this tool that performs much like a profit-sharing retirement plan, rewarding longevity. The curiosity is out there more than ever before.
Interest in ESOP boils down to these fundamentals:
An ESOP is about making sense of cents
An ESOP is a more long-term strategy, but it is neither recession-proof nor immune to disruption caused by a pandemic. And it may take a bit of reshuffling in your management structure.
First, you must be a C or S corporation (or taxed as one) to set up an ESOP. Since the taxation rules for C versus S are different, sometimes a company will switch corporation status to transact their ESOP.
Second, it is recommended that company pretax profits be at least $250,000 annually with controllable expenses. Businesses with only a few key clients are not good candidates, since the risk of losing one can hurt cash flow, which needs to be steady with growing revenues. Industry conditions should be good. Startups should wait about five years to consider an ESOP.
Third, the company ideally should have at least 20 employees led by a strong management team. (ESOP candidates shouldn’t fret if they don’t have such a structure in place; this may be the incentive to create one.)
Here are other considerations in this category that are necessary to understand to advance the ESOP conversation:
- Do the employees run the company, have access to the financials and know everyone else’s compensation? The answer (to each) is a resounding “no.”
- After the owner has transitioned the reigns to the ESOP, do the employees control the day-to-day functions? No, a board of directors (BOD), which is comprised primarily of executive management, votes on most business issues that run the company. Corporate documents establishing the initial BOD and the rules for nominating the BOD are set before the ESOP is closed.
- Are the employees also shareholders? No, they are beneficiaries of the ESOP trust. Collectively the ESOP is just one shareholder.
An ESOP is about maximizing money
An ESOP can solve the owner exit strategy question in terms of leaving the business intact without much fuss. But that’s just the start when you consider:
- The owner can experience indefinite deferral (and possible elimination) of capital gains taxes that otherwise could come from selling the business.
- The company (via the ESOP) gains year after year potential tax mitigation, maximizing future cash flow and profits.
- An ESOP can be funded through a third-party financial institution (such as a bank) or from the owner acting in that role.
- ESOPs can easily be integrated with other tools, such as IRC 409A deferred compensation plans and personal legacy strategies, such as charitable planning and family gifting.
- There is a flexible timetable for selling shareholders to exit; it can be short or long.
An ESOP is about culture and continuity
A wholesale plumbing supplier went through the ESOP process with us within the past year. One of the company’s co-owners began with the business in the early 1970s when its store was a few employees handling customers’ transactions at a tiny counter.
Fast forward four decades; it has grown to 40 employees with 24,000 square feet of warehouse space on four acres and a thriving design component. There was already a 401k program in place and a loyal staff. The owners looked at potentially different succession options, then told my OneAmerica colleague John McGuire, “The reason we went with the ESOP was we wanted the company to be around forever. Our employees who got us where we are today can now take the company and run with it.”
Because the culture is so great at this company, it is an ideal candidate for success. The “rank and file” employees are now motivated to keep innovating and growing, because those workers who become vested will experience a positive economic impact in future years.
And the reality is the combination of an ESOP and a 401k provides more wealth, more diversification and a balance in the timing of receiving the retirement income. All of it will optimize the outcomes for plan participants.
An ESOP might also provide a “golden handcuffs”-type of allure to important (and highly compensated) employees who otherwise might seek greener pastures. It can be a powerful retention tool.
To the financial advisor, all of this means more opportunity. We are telling them, “I can help you help your business-owner clients” with the added benefit that an ESOP can be right for the community, right for the employer, right for employees and right for the business owner.
About the author: Jackie Salmon, A.S.A., M.A.A.A. is the ESOP National Practice leader for Indianapolis-based OneAmerica. She handles a variety of roles related to ESOPs, from consulting to sales and marketing.
Jackie Salmon is the founder of Jackie Salmon Consulting, where she works specifically on ESOPs.
