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]
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.[4] 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.[5] 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 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,[6] and you will also likely want to secure a specialized attorney for the process as well.[7] 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.
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.[8] It is also a potential option to build new equity since all contributions to an ESOP are tax-deductible.[9] 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.[10] 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.[11]
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.
[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
[4] 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)
[5] 2 Taxation of Securities Transactions § 25.02 (2019).
[6] 2 Taxation of Securities Transactions
[7] 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/
[8] ESOPs: The Basics and the Benefits.
[9] ESOPs: The Basics and the Benefits
[10] Ronald Kimmons. ESOP Disadvantages. Bizfluent. (2017) https://bizfluent.com/list-7308255-esop-disadvantages.html
[11] Michael McGinley. The Pros & Cons of ESOPs. Prairie. (2019) http://www.prairiecap.com/the-pros-cons-of-esops
About the author
Isaac Isaiah Carr, JD MBA is founder, CEO, and business attorney of CCSK Law, a kingdom-driven law firm. Launched 5 years ago, CCSK Law grew from a single member firm to a 10 person team. His areas of focus include business formation and strategy, contract writing, sales, and corporate finance. Often referred to as an entrepreneur with a law degree, Isaac is able to offer business strategy utilizing creative solutions guided by legal and accounting principles that are then well executed in law. Experience in a variety of industries including real estate, hospitality, automotive, e-commerce, professional services, and healthcare. Successfully negotiated and closed multi-million-dollar transactions, ranging from $1.8M to $10M, with private investors, corporate leaders, and municipalities. Ultimately, he builds sustainable structures for systematic growth. Graduated from Valparaiso University Law School summa cum laude with his Juris Doctorate as well as the AACSB-accredited Valparaiso University School of Business with his Master’s in Business Administration. Passionate about education in all forms, Isaac is involved in the nonprofit organizations of SCORE, Neighbors’ Educational Opportunities (NEO) and New Vistas High School, ValpoNext, and Music Neighbors.