ESOPs can help save Capitalism and make a more equitable America.
This is article #2
We have employee ownership in America. Through a unique M&A transaction, corporate tax savings and employee retirement plan that most people have never heard of or don’t know a lot about. It’s called an ESOP, which stands for Employee Stock Ownership Plan.
Back in the 1950’s, a corporate lawyer named Louis Kelso constructed the ESOP, with the idea of making it easier for owners to sell their businesses to employees and make a more equitable America.
How it works. An ESOP is a trust, a separate legal entity from the corporation. The trust is a transition vehicle, enabling an owner or owners of a company to sell their company’s shares to the employees, creating an employee owned company or what you call an ESOP company.
The transition is a M&A transaction or exit for the owner. In the transaction the owner’s equity is effectively sold to the trust and financed by the company with cash on-hand, a loan the company takes and future cash flows. The owner receives a note (debt) from the company for the majority of the sale. The company’s stock (equity) is then distributed over time to the employees and held in employee retirement accounts inside the trust.
After the transaction if the ESOP trust holds all the shares of the company the company will never have to pay taxes ever again. The trust then becomes the actual owner of the company. It’s like a leveraged buyout but the employees don’t buy out the owner with their own personal cash.
ESOP trusts hold employee defined contribution plans, like 401(k)s inside the trust. The main difference between a 401k and an ESOP is that you can only hold the company stock in your account and a % of the employee’s salary is not withheld to obtain the stock.
In 1974, congress reformed the tax code to help make ESOPs attractive in the hopes they would become a mainstream option for SMB (Small to medium size businesses) succession planning by providing massive tax incentives to owners to sell their companies to their employees. By making more employees owners in companies the government could increase their tax base as employees pay capital gains tax on their distributions at retirement or when they leave the company. If they leave the company and the company is private the company buys back the stock at the current valuation. Every year ESOPs are valued or mark-to-mark by a 3rd party valuation company. If the company is a publicly traded company the employee can sell their stock on the stock market.
C corps and S corps can both have ESOP trusts. If the corporation is an S corporation, whatever % of equity the trust owns in the corporation, it does not have to pay tax on that share of earnings. The ESOP trust is a tax exempt entity. If 100% of the companies’ shares are in the ESOP trust then the company will be 100% exempt from both state and federal taxes. Yes, you heard me right, no taxes.
By not having to pay taxes the ESOP trust can build a reserve of retained earnings. This can then be used to pay the owner back through the note, payout employees when they leave or retire or used to acquire companies.
The Numbers
There are estimated to be around 11M employers in the US [1] and 6,400 of them are ESOPs. 90% of ESOPs are run by private companies and 10% are publicly traded. In total ESOPs, hold over $1.6T in assets. 14M people are participating in ESOPs and 10M people are actively working and employed by an ESOP [2] or 7%-8% of the US workforce.
Familiar employee owned ESOPs, include Publix Supermarkets the largest ESOP in the US, W. L. Gore & Associates the maker of Gore-Tex clothing products and Wawa convenience stores and gas stations.
There are millionaires working the aisles of the Publix super market. Did you ever wonder why the super-market is so great?
In the travel industry (the industry I work in), I know of four ESOPs. The Proximity Hotel, World Travel Inc., Travel & Transport (acquired by CTM) and TravelStore which are corporate travel agencies also known as TMCs. If there are more out there please let me know.
The majority of ESOPs are in manufacturing and industrial verticals. For unknown reasons, ESOPs have been slightly decreasing in numbers over the last 5-years.
If ESOPs are not loved by American companies then what are they used for?
1) It’s a way for the current owner to sell their company and exit the business in a M&A transaction. This is an alternative to selling to a strategic buyer or private equity firm.
2) A possible tax scheme for family businesses to shield or reduce the amount of taxes they have to pay the government.
3) A succession strategy for one generation to transition ownership to the next generation of family members and management.
What’s interesting is that I have never heard anyone say, I am going to create an ESOP so that my employees can become owners.
Complex structuring, cost prohibitive, professional service providers
When you dig into how to set up an ESOP, your head will start to spin. It’s not like you can just go to LegalZoom and set up an ESOP. ESOPs cost around $250,000 to execute. The best ESOP consultants can execute an ESOP for a company from start to finish in 90–120 days.
Some ESOP professionals say that If your company doesn’t pay more than $250,000 in taxes or you have fewer than 13 employees the numbers don’t make sense.
Trust, Trustee, Plan Administer, Treasury, Valuation Appraiser, Brokerage Firm, Lawyers, Accountants, CPAs. These are all the professional service providers involved to execute an ESOP M&A transaction.
Ultimately, I believe this is part of the problem as to why we don’t have more ESOPs. It’s not only expensive to set up, it’s complicated for the average Joe SMB owner to understand.
The average American company has fewer than five employees and generates less than $1 million in revenue so how can the majority of businesses in America become ESOPs? They can’t. I think this is the biggest downfall of the current government program.
Maybe there is a way for Congress to create the mini-ESOP for the majority of SMBs in America.
ESOPs can help save American capitalism and make a more equitable America.
Benefits:
- Current owners sell their company and receive cash at closing, cash over time (deferred compensation) and save on paying taxes if structured correctly. They get the exit they want.
- Employees become owners. Employees’ salaries typically increase and they start building wealth. The company flourishes because now all the employees have an ownership stake in the success and no longer feel expendable. Employees build retirement accounts over time that can be worth millions.
- The corporation gets massive tax breaks through the ESOP trust tie up and ultimately grows faster. Cash flow increases, revenue increases, productivity increases.
- The US government increases their tax base. The government gets new tax payers. Employees will pay capital gains taxes on their distributions when they retire or leave the company. This reduces the current challenge the government faces with retirement deficits building. Some even question whether the current social security system is sustainable.
ESOPs effectively spread the wealth across all the employees of the company making for a more equitable America.
How to step in and start supporting and building an ownership-based America.
1. Owners: Start talking with your employees about the idea of them becoming owners. Just ask them if this is something they are interested in having a discussion about with ownership and management. How would they feel about this opportunity?
2. Employees: Start talking with your owners and management about the idea of all the employees and managers becoming owners. Would they be open to discussing this? This is a much better strategy for everyone than starting or launching a union.
3. Start researching how your company can become an ESOP. It is a viable sell-side acquisition transaction for owners looking to retire and passing ownership to their employees.
I’ve recently affiliated with one of the leading companies in the US that executes ESOPs. This is an expansion of my current Travel Technology M&A Broker business. If you’re interested in learning about becoming an ESOP please email me. If you’re an employee of an ESOP I’d love to hear from you as well.
Bio:
Matt Zito provides strategic advisory, business development and M&A services for global travel technology companies. He is interested in building an ownership-based economy in America and the world. He can be reached via WhatsApp 1–207–460–0740 or email: mdz@mattzito.com
[2] https://www.nceo.org/articles/employee-ownership-by-the-numbers#1
