In an early post, we discussed the benefits and challenges of selling a business to a key employee. It is an option that allows you to put someone familiar with the company and its operations in charge and mitigates some of the uncertainty surrounding new ownership, though it isn’t always the most economical method. However, while selecting a single key employee to serve a new owner is an obvious choice, there is also another option for those looking to keep ownership within the company’s ranks: sell to all of your employees. When it comes to transferring ownership across multiple employees, there are generally two methods to consider: a stock option plan or an Employee Stock Ownership Plan (ESOP). While somewhat similar, they are different enough that they offer unique benefits and challenges that can make one preferable over the other.
Stock Options
Stock option plans are generally used to compensate
and retain employees by allowing them the right to buy a specific number of
shares of company stock for a defined number of years. Capital stock is
generally handled through either a compensatory plan, where the issuing company
incurs additional costs because shares come at a price that is below the market
value, or a non-compensatory plan, where the stock is offered to employees at
no additional cost to the issuing corporation.[1]
Additionally, there
are two main types of stock options: incentive stock options (ISOs) and
non-qualified options (NSOs). ISOs are a tax-favored device that is good for
corporations looking to attract new management and retain existing employees,
and so long as certain rules are met, employees do not have to pay taxes on the
spread. With an NSO, the company has total discretion to decide what the
exercise price will be, how long an employee must wait to exercise it, and the
employee’s work status.[2] Also, an employee is
excepted to pay taxes on the spread just as they would for their wages, and as
such the company can complete a tax deduction on one as well.[3]
[1] 2 Applying GAAP and GAAS § 15.05 (2019).
[2] Johnson, E. L. (2000). Waste not, want not: An analysis of stock option plans, executive compensation, and the proper standard of waste. J. Corp. L., 26, 145.
[3] Rosen, C. (1998, June 1). ESOPs or Stock Options: Which Will Work for Your Company? Inc. Retrieved from https://www.inc.com/articles/1998/06/15819.html
Employee Stock Ownership Plans (ESOP)
With an ESOP, a company creates an employee stock ownership trust fund, making annual contributions to the trust, usually in the form of new or treasury stock, or cash or pay-down debt to acquire existing company stock.[1] This provides a flexible and scalable option that ensures the continuation of the business.
However, an ESOP is a complex process that has several
key requirements, including ownership of all qualifying employer securities, as
well as voting and diversification rights for all qualified participants.[2] Also, a business that
decides to initiate an ESOP will need a large enough workforce that has a low turnover
rate, as large employee migrations during within an ESOP can create lead to a
lack of necessary resources to maintain the system. It is highly recommended
that you go over any regulatory requirements before establishing an ESOP,[3] and you will also likely
want to secure a specialized attorney for the process as well.[4]
Which method you
choose to handle a shift in ownership will vary, as both have their advantages
and disadvantages. Stock plans are generally seen as just options to help
recruit talent, while an ESOP has the potential to be a critical part of a
company’s business operations, even beyond the need to transfer ownership.
However, the sheer amount of administrative labor and regulatory requirements
involved in an ESOP is far more complex than a standard stock plan. Ultimately
it is a matter of personal preference and the needs of the employees.
[1] ESOPs: The Basics and the Benefits. (n.d.). Mercer Capital. Retrieved from https://mercercapital.com/article/esops-the-basics-and-the-benefits/(Reprinted from Mercer Capital’s Bizval.com, 2000, 9.2)
[2] 2 Taxation of Securities Transactions § 25.02 (2019).
[3] 2 Taxation of Securities Transactions
[4] ESOP Attorney – How to Hire One and Why It Matters. (2019, February 6). Alpha Architect. Retrieved from https://alphaarchitect.com/2017/12/12/esop-attorney-how-to-hire-one-and-why-it-matters/
The Benefits & Drawbacks of Selling to All Employees
Regardless of which method of you choose, moving
ownership across all of your employees has both benefits and drawbacks to
consider ahead of time. On the plus side, the seller will often have an easier
time getting employee commitment through this method when compared to selling
to a single employee, particularly with an ESOP. Everyone in the company now
receives retirement benefits, and since the stock is allocated based on a
contribution by the company, employees are not required to pay for this benefit
either.[1] It is also a potential
option to build new equity since all contributions to an ESOP are tax
deductible.[2]
However, whether you
go with an ESOP or simply provide stock options, selling to all employees has
potential complications. For one, despite the opportunity to build equity,
ESOPs are often difficult and expensive to establish, with high initial costs
(upwards of $50,000) and annuals after the ESOP is functioning.[3] It also requires effective
drafting and planning, as if employees do start leaving, it could lead to a
massive cash crunch as the company looks to fill the gap left by an employee’s
departure.[4]
[1] ESOPs: The Basics and the Benefits.
[2] ESOPs: The Basics and the Benefits
[3] Ronald Kimmons. ESOP Disadvantages. Bizfluent. (2017) https://bizfluent.com/list-7308255-esop-disadvantages.html
[4] Michael McGinley. The Pros & Cons of ESOPs. Prairie. (2019) http://www.prairiecap.com/the-pros-cons-of-esops
Taking Stock of Your Options
Whether you decide to go with stock options or an ESOP, selling to your employees is a fine way to ensure the longevity of your company, even if you are no longer a part of it. By getting employees invested in your company (quite literally), you bolster their desire to see the company grow and improve, while also offering the opportunity to grow and improve. Though its feasibility will need to be determined by accountants, lawyers, and administrators, in the right situation it is an ideal option for employees, shareholders, and employers.