A recent uptick in formations of employee stock ownership plans, known as ESOPs, has put the spotlight on the combined employee benefit and small business management succession tool that has been in existence since 1956. “We’re seeing tons of activity,” says Keith Butcher, a founder of Butcher Joseph Hayes, a Clayton, Mo.-based investment banking firm.

A variety of factors — the low cost of debt, rising capital gains tax rates, emerging “social capitalism” — may be contributing to the bump, Butcher suspects. For the past decade, the number of active ESOPs in existence has held steady at around 7,000, but the number may now be rising, he says. Some benefit advisers’ small business clients might be candidates for establishing an ESOP, but their motivation and business circumstances must align for the idea to make sense.

For one thing, setting up and maintaining an ESOP can be relatively expensive, particularly for companies valued at less than $10 million. Much of these costs are fixed, and thus would be proportionately less expensive for larger companies.

ESOPs have received some negative media attention lately. A Wall Street Journal article highlighted U.S. Department of Labor litigation against valuation firms, and business owners responsible for stock valuations, enabling owners to fetch above-market prices for their companies, leading to disastrous results for employees. The practice is not widespread.

Bad apples aside, honestly managed ESOPs aren’t for everyone. If the business owner is only looking for a way to get top dollar for the company, he or she is probably better off selling it to a strategic buyer, Butcher says. That’s because the right buyer can exploit synergies with enterprises it already owns by adding the newly acquired company to the equation.

That prospect will motivate a strategic buyer to pay more than either an ESOP or a private equity company could, as the company would have had a lower valuation if bought by either of those entities.

Needed: Management buy-in

“For an ESOP to be successful,” says Joseph Strycharz, a partner at Butcher Joseph Hayes, “you need buy-in from management and employees.” In fact, management buy-in is most important because as the retirement-seeking owner begins to ease away from the day-to-day maintenance of the business, remaining management must be motivated to run the company profitably enough to generate the cash required to keep the ESOP alive and continue to buy out the owner.

“Going around saying ‘rah rah rah’ [to whip up enthusiasm among employees] probably isn’t the best way to go,” Strycharz says. ESOPs should never be considered an alternative to a standard retirement plan, he adds.

ESOPs confer certain tax benefits to owners, such as enabling them to use their company to buy them out with pre-tax dollars, and to defer recognizing capital gains on sold stock if cash generated by the sale is properly reinvested. However, tax benefits should only be seen as “the cherry on the top,” Butcher says.

“If an owner is just focusing on the tax benefit, he’ll probably come out ahead [net of tax benefits] by selling to a strategic buyer,” he adds.

ESOP basics

ESOPs are ERISA-sanctioned benefit plans whose purpose is to hold employer stock, which ideally will appreciate in value over time, on behalf of plan participants. The company either contributes cash to the ESOP to enable it to buy the stock, or the ESOP finances large stock purchases with bank debt or seller financing.

In a financed transaction, the company’s periodic cash contributions must be sufficient for the ESOP to service its debt.

The employer stock is valued annually by an independent appraiser; the company can’t use its own accounting firm for the purpose. In privately held companies, employees’ vested interest in employer stock can be put back to the company at the current appraised value when they have satisfied vesting, age or service requirements. In public companies, vested ESOP participants generally can sell shares on the open market.

Stolz is a freelance writer based in Rockville, Md.

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