There are a lot of myths and mysteries that surround employee stock ownership plans (ESOPs) and some of these misconceptions can scare landscape company owners away from considering this business option.
Make no mistake, some ESOP structures are complex, but they don’t have to be intimidating. Here are the basics of what an ESOP is, its benefits and drawbacks and who should consider pursuing one.
What are ESOPs?
Probably one of the biggest issues with ESOPs is that not very many people understand them entirely or know what they do.
“Basically, the shareholders of the company sell a block of their stock to a trust,” says Trey Ball, CFO and general counsel for Michael Hatcher and Associates, Inc. based in Olive Branch, Mississippi. “This trust is for the benefit of every employee of the company. If the company increases in value, the employees will see their ESOP account increase. Once the employee retires, she will receive payments for the value of their account.”
While it is called an employee stock ownership plan, employees do not purchase the stock. Rather, it is granted through profit sharing and eventually, the employee will become vested. The longest vesting schedule is six years.
“In general, an ESOP is a qualified retirement plan that looks similar to a 401(k) profit sharing plan,” says Philip DeDominicis, managing director of investment banking with Menke & Associates, Inc., which specializes in structuring ESOPs. “401(k) profit sharing plans are funded by the business, not the individual. They’re typically decided upon, meaning how much money, at the end of the year, when the board knows whether the company’s made money or not. And then it’s for all eligible employees.”
In general, the difference between an ESOP and a 401(k) is on the investment side. Rather than the money going to an individual’s account like with a 401(k), it ends up in the ESOP trust. The investments in the trust are controlled by the board of directors of the company, and ESOPs can invest in the company’s stock, where a 401(k) cannot.
DeDominicis says that in almost all cases, ESOPs are added to the compensation plan so they are not replacing a 401(k) plan but are a second retirement benefit. “Almost all of our clients keep the 401(k),” he says. “We encourage the employee to put their money into their 401(k). But employers’ money, typically, starts going to the ESOP to help create liquidity for the current shareholder base. Meaning, any previous 401(k) match or profit sharing contribution mechanism is halted and replaced with future profit sharing funds going to the ESOP.”
Pros and cons of ESOPs
The main benefits of ESOPs are it creates liquidity and/or a succession plan for the business, provides a company-funded retirement benefit for employees and motivates employees to add value to the company. “An ESOP is a way to either take care of the entire succession plan or to simply create some liquidity for the current shareholders,” DeDominicis says.