Might ESOP Benefits Put the Success in Succession?

Many businesses face a potential succession problem. One solution has the added advantage of providing employees with a unique retirement benefit — one that typically does not require them to make any out-of-pocket investment.

U.S. Census Bureau data shows more than half of American business owners are older than age 55. In addition, surveys by the Economic Policy Institute, PNC Bank and others show 80% of business owners do not have a transition or succession plan — a problem made worse in cases where owners don’t have family members interested in taking over the business or an option to sell the company.

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Employee stock ownership plans, or ESOPs, are an alternative that is sparking growing interest and exploration as a succession plan, particularly by closely held or middle-market businesses for whom other ownership transition options may not be feasible.

“If you’re not receiving an offer to buy your company, if your children don’t want to take it over and if you’re too small to be picked off by private equity, an ESOP buyout can be an important option,” said Joseph Blasi, a professor and director of the Institute for the Study of Employee Ownership and Profit Sharing at the Rutgers University School of Management and Labor Relations.

Research by ESOP advisory firm CSG Partners found that, between 2020 and 2022, there were 299 net-new leveraged ESOPs, the largest expansion period in two decades — with middle-market companies appearing to drive the growth.

“There’s more ESOP education and awareness out there,” said Andrew Nikolai, CFA, a vice president at CSG Partners. “Historically, and even still today, we talk to a business owner about an ESOP, and a lot of times we get the response, ‘This is great. Why did I not know about this? Why are more people not talking about this?’”

How an ESOP Works

To facilitate such a plan, a retiring business owner sells shares of the business to an ESOP trust, with the trust often securing financing to purchase the shares and repaying the loan with future company profits. Over time, the trust then distributes those shares to the company’s employees as a retirement benefit. ESOPs differ from employee stock option plans or purchase plans in that shares typically are given to employees rather than offered for them to purchase.

From there, when employees leave the company or retire, they “sell” their shares back to the trust, cashing them out at market value.

While ESOPs are governed by many of the same rules as 401(k) plans, they are different in a few key ways:

Employees get shares, not dollars, and the value of those shares can rise or fall, depending on future company performance. This means employees in an ESOP have an ongoing interest in ensuring great organizational performance because they stand to benefit. It also means that communicating to employees the value in their plans is more nuanced and challenging than it is for a 401(k).
Further, unlike 401(k) plans — where employees own the organization’s contribution and hold it in their own personal accounts — ESOP shares are held on behalf of the employees. After an employee leaves an ESOP company, the employer can take several years — up to nearly 11, in some cases — to distribute the full value of that employee’s shares.
- Distribution payment can be made either in a lump sum or in “substantially equal” installments over a period of five years.
- If the balance is very large (greater than $1.38 million in 2024), the five-year installment period can be extended to as long as 10 years.
- Depending on the date of termination and the ESOP’s annual reporting period, it may take up to nearly 11 years to complete the distribution payout.
Many organizations offer an ESOP in addition to another retirement plan, such as a 401(k). Employees who can afford to contribute to the 401(k) can take advantage of both plans. Employees who can’t contribute to the 401(k) still get the benefit of the ESOP, which typically requires no out-of-pocket contribution from employees.

ESOPs have been found to increase job tenure and reduce quit rates by participants, according to research from the National Center for Employee Ownership. According to its study, employees participating in these plans also have higher median wage income and household net wealth.

“You can turn people making $50,000 a year into millionaires over time, when they didn’t personally contribute a dollar to the ESOP,” Nikolai said. “Over time, this can be a really powerful tool to create employee wealth.”

Benefits of ESOPs

While there are factors to consider related to business structure and setup costs — and there is work to be done in making them equally accessible to minority employees — ESOPs may offer a variety of benefits to the companies that implement them and to their localities.

Business Continuity

An ESOP may be preferred when other merger-and-acquisition succession plans aren’t feasible or desirable.

“A motivation for a lot of business owners is they want to see their business continue in some form, to have a legacy,” said Douglas Kruse, a professor and research director of the Institute for the Study of Employee Ownership and Profit Sharing at Rutgers. “Selling to the employees, the people who know the business best, can be very attractive.”

Tax Advantages

Owners can take certain deductions and defer capital gains taxes if they sell at least 30% of the business to an ESOP trust, and employee taxes on distributions are deferred until withdrawal.

Social and Community Impact

There can be social benefits to shifting ownership of a company to its employees, and doing so can keep corporate dollars within the community.

“A lot of policymakers are interested in employee ownership, given the increase in retiring owners, as a way to enhance community stability — to make sure jobs stay in the community, that you maintain the local tax base and capital isn’t shifted elsewhere,” Kruse said. “That’s an incentive for a lot of business owners as well.”

Keys to Successful Implementation

Companies of varying sizes utilize ESOPs (with Walmart, Home Depot and Target topping the list based on number of participants), but generally they won’t work for companies that are too small. A feasibility analysis is generally the first step in exploring an ESOP. For businesses that end up going another route, there are options such as an employee ownership trust.

Kruse noted that ESOPs are most often set up within companies with more than 50 employees — although he cited Switchback Brewing Company in Vermont as an example of a smaller business that opted into an ESOP.

An ESOP will likely work best in a company that:

Does not have “bad to rotten labor relations,” and whose employees are open to the idea of an employee-ownership structure, Blasi said.
Establishes an environment in which employees have some say in company decisions and a sense of job security, Kruse added.
Offers open communication with workers about how the ESOP works and the status of the business, which creates an ownership culture that incentivizes workers to work toward company growth, Nikolai said.

The Impact of ESOPs

From a total rewards standpoint, offering current and potential employees an ownership stake in the company can be a powerful attraction and retention tool that makes businesses stand out, Nikolai said.

Additionally, Kruse and Blasi stressed that employee ownership structures may help workers build wealth in a way that wages alone cannot address.

“The bottom line is that shares of equity and shares of profits really are the main ways workers can change the economics of their lives in a way that truly affects them and their families,” Blasi said. “You’re not likely to have an impact on wealth inequality without equity ownership or profit sharing by employees.”

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