ESOP Basics - MBO Ventures

What is an ESOP?

Textbook definition

It is an Employee Stock Ownership Plan, an ERISA-authorized, defined contribution plan that invests in employer securities.

Real-world explanation

An Employee stock ownership plan (ESOPs) is a corporate finance tool that enables business owners to partially or completely sell their companies to their employees. The US Congress set up ESOPs on purpose. (See Video) They wanted to give business owners tremendous tax incentives to use ESOPs.

An owner can use an ESOP to sell 30%, 40%, or 100% to it’s employees, and defer taxes indefinitely on this sale. ESOPs are used in management buyouts, as well as family succession. ESOPs are used to take cash off the table, and they are used to grow the firm.

With an ESOP, you as the owner can continue to manage the firm and maintain upside potential. When selling to the ESOP, owners receive fair market value for their ownership stake and realize significant personal and corporate tax advantages.

Owners defer paying tax on the sale of the company indefinitely

Any portion of the firm you sell to the ESOP is tax deferred (See Video) as long as you invest the proceeds in Qualified Replacement Property (QRP). What is QRP?
As long as you hold onto the QRP, you pay no tax.
If QRP is held until death, your heirs receive a step-up in basis, eliminating all capital gains and income taxes.

The government subsidizes the buyout of the company

To purchase the company from the owner, the ESOP borrows the money. When you borrow money, you must pay back interest and principal – similar to a home mortgage. A huge advantage of an ESOP is that the principal is tax deductible. Please re-read that again. Your principal is tax deductible! This is the equivalent of the government giving money to the employees to buy the firm. This means that the government is subsidizing the buyout of the company.

Company cash flow doubles the moment an esop is completed

When an owner sells the company to the employees in an ESOP, the company runs tax-free, resulting in significant increased cash flow. If your company pays 50% in taxes, your cash flow doubles!
1. If the company is 100% ESOP owned by the employees as an S-Corp, the company runs tax free indefinitely.
2. If the company chooses a Minority-Owned ESOP (meaning only a percentage of the company is ESOP owned by the employees) then the ESOP can run 100% tax free for 3-5 years while paying down the tax deductible debt.
3. Since the ESOP earns money tax free, you have gained a significant cash savings.
  1. You can use this money to pay down the loan.
  2. You can use this savings and reinvest it into your company’s growth.
When an ESOP buys a company, the company can now take a tax deduction on both the interest AND the principal. (Normally only the interest is tax deductible).

You, as the owner, do not have to guarantee the loan

In order to buy the company, the ESOP borrows money using the Company’s balance sheet.

The owners should NOT have to personally guarantee the loans.
The employees should never personally guarantee the loans.

Other advantages of an esop

No employee funding required. See our video on how this works
If there are multiple company owners, each owner can sell some, or all, of their shares to the ESOP. It is NOT necessary that all owners sell their shares equally.
The owner can still manage the day to day operations and have upside potential even if they sell 100% of the company.
Employees gain a valued retirement benefit (company stock)
1. Shares from the ESOP are allocated to employee ESOP accounts (similar to 401K)
2. Employees must be 100% vested within 3 to 6 years
Employees keep their jobs and are more invested in company success; act like owners; work harder and better

History of ESOPs

ESOP Funding

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