THE BLOG
07/10/2014 10:53 am ET Updated Aug 28, 2014

Should You Think About an ESOP?

I'm a big fan of ESOPs, or Employee Stock Ownership Plans. In the right circumstance an ESOP might just be the ticket you've wanted to help you leave your business.

I've learned that ESOPs are complicated beasts. There are lots of moving parts and at some point you as a selling owner might ask, why bother? At the same time, if you master the intricacies of doing an ESOP, it just might be the best decision you've made for you and your employees.

Who is an ESOP good for?

I think an ESOP is best for a selling owner who has developed a good management team and wants to make sure that what they've created in their business continues after they move one. If you decide to sell your company to a third party, it's almost a certainty your company will be a very different animal very quickly.

If you believe in open book management, have a good management team and your team likes the idea of having the stock owned by an ESOP, this could be a good succession strategy for you. Oh, and your company should have some size. In my opinion an ESOP works best for companies that have more than fifty employees and do more than $5,000,000 in sales.

Who shouldn't do an ESOP?

Small companies shouldn't do an ESOP. They are just too costly and too complicated. Also, smaller companies tend to not develop management structures and training programs to bring the next level of managers along.

Companies where managers don't want to share ownership with all the employees are another signal an ESOP might not be a good idea for you. If you don't think sharing information with your employes is a good idea or you really don't care what happens with your company after you leave, don't bother with an ESOP. It'll be too much work for you.

I've heard ESOPs are really expensive, is this true?

An ESOP done the right way will often cost between $150,000 and $250,000 to set up. Several people from the ESOP organizations have told me it can be done for less. Yes, that's true and I find that when they are done for less there are often some shortcuts used that can come back and bite you.

The best way to think about doing an ESOP is comparing the cost to what an investment banker would charge you to sell your business. If the enterprise value of your company is $5 million or more an ESOP certainly won't be any more expensive than hiring an investment banker. If the value of your company is less, you might just decide an ESOP is not for you.

What about taxes?

Here's where it gets really interesting. An ESOP can be a very attractive way of leaving your business and it can be an even more attractive way to run a business. If a business decides to become an ESOP and converts to a Sub Chapter S Corporation, the portion of the business that's owned by the ESOP pays no income tax. Yes, you read that right.

If you're a seller, it's possible to structure the sale so you don't pay taxes on the proceeds you receive. At the very worst, you'll pay capital gains taxes only on the proceeds from selling your company. In most cases your taxes will be much lower than if you sell to anyone else.

Give me some guidelines.

OK, here is some things you should think about is you're going to do an ESOP.

1. Start with the ESOP owning a small part of the company, likely 30 percent to start. That way if the deal doesn't work out you can unwind what you've put together.

2. Make sure you like and your employees are comfortable with open book management. ESOPs are not required to share numbers. At the same time, those that do tend to have better performance.

3. Make sure your managers are in favor of doing an ESOP. Sometimes managers just want to own the company without rank and file employees sharing in the gains and losses of the business.

4. Make sure your company has a bright future. ESOPs can be a real boon to employee morale. If the company hits a rough spot, the value of ESOP ownership will go down and this could cause employee moral problems.

5. Get a great team to help you assemble an ESOP. One of the reasons that a well designed ESOP is expensive is because good professionals that know what they're doing are expensive. You want a good team. It'll likely save you money in the long run.

6. Attend ESOP meetings to learn about what options you have. There are often local and certainly national ESOP meetings. Most of these gatherings have sessions for those companies who are considering an ESOP. You'll learn valuable information at these meetings.

7. Find others who have done ESOPs and talk to them about their experience. Make sure you ask people who have done an ESOP transaction what they didn't like and what they would do differently this time around.

8. Most importantly, take your time. This is a big decision that's has lots of twists and turns. It'll take you a while to get comfortable and understand the nature of the transaction. Taking time to truly understand your options will pay off in the end.

Do you think an ESOP might be in your future? What do you think works about an ESOP for you?