The Investment Scientist

How business owners can use an ESOP

Posted on: November 13, 2012

Consider an Employee Stock Ownership Plan

[Based on conversation with and material provided by Ben Wells] For the last 20 years, Jack has owned  a custom machining business. He is 55 and would like to diversify his assets, which are all tied up in the business.

Jan runs a manufacturing business. Several of her family members own stock in the company and they would like to sell their stock. However, there is no market for their shares.

James runs a production consulting firm. He needs capital to expand the business and would like to find a way to retain and motivate the firm’s employees.

For Jack, Jan and James, an Employee Stock Ownership Plan (ESOP) could be the answer.

What is an ESOP?

An ESOP is an employee benefit plan that makes the employees beneficial owners of stock in the company. Several features make ESOPs unique compared to other employee benefit plans.

  1. Only an ESOP is required by law to invest primarily in the securities of the sponsoring employer.
  2. An ESOP is unique among qualified employee benefit plans in its ability to borrow money.
  3. The tax code has several provisions that encourage ESOPs and provide benefits to the selling shareholder and company as well as the employees.

How does an ESOP work?

It’s not complicated:

  • The company borrows money from a bank and lends it to the ESOP.
  • The ESOP uses the money to buy shares of company stock from the owner(s).
  • The company makes annual tax-deductible contributions to the ESOP.
  • The ESOP uses the contributions to repay its loan from the company, which in turn uses it to repay its loan to the bank.

In summary, the company takes out a loan to buy out the owner(s) through an ESOP, and the employees of the company end up owning the firm through the ESOP.

What is it good for?

The most important use of ESOP is facilitating the owner(s) exiting the business. The owner(s) will no longer need an external buyer or an internal successor who may or may not be able to finance the deal. With ESOP, the firm secures financing for the employees to buy out the owners, and thus the employees become the new owners.

In additional, ESOP can be used to align the interest of the employees with the firm, as well as providing an alternative way of financing.

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC. He is also a regular contributor to Morningstar Advisor and Physicians Practice. To explore a long-term wealth advisory relationship, schedule a discovery meeting (phone call) with him.



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