What Is an Employee-Owned Company

What are Employee-Owned Companies (ESOPs)?

When a business owner wants to retire or move on to something new, they have the option to sell ownership to employees. Selling the business to employees is a viable option since it ensures continuity. There is also little to no hassle involved. Your employees already know the ins and outs of the company, and thus you won’t spend time explaining how everything works.

When transferring ownership to employees, the business owner can either sell to his most trusted team member or to all qualified employees. The owner can give share ownership to all employees through an ESOP (Employee Stock Ownership Plan).

But how does an ESOP work? Does it mean every employee becomes a manager? Do all employees get a share in the company’s profits? This article will provide information and insights to help you understand how employee-owned companies operate.

What To Know About Employee-Owned Companies

An employee-owned company is one where employees own part or all of the shares of the business. There are many forms of employee ownership, stock grants, worker cooperatives, and stock options, to name a few. Each offers different financial benefits and responsibilities, but the goal is the same. They are all geared to fostering and promoting employee ownership of a business.

The ESOP is the most common form of employee ownership in the United States. As of the publication of this post, there are approximately 6,482 ESOPs in the US, with roughly 14 million total employee participants. ESOP plans allow employees to own a portion or 100% of company shares.

How Do Employee-Owned Companies Work?

The way an employee-owned company operates depends on the plan or method used to transfer ownership to employees. In the case of an ESOP, the company will first establish a trust in which they make annual share contributions for employees that qualify.

The company can use the ESOP trust fund to buy stock from the selling shareholder or departing owner. They can also use it to hold shares for employees. The company can also use the ESOP trust to borrow money for funding the share sale or transfer.

The business owner looking to transfer ownership will sell his shares to the ESOP trust fund. The shares then go to qualified employees. They are held safely in the ESOP trust.

An employee must first become vested in the program to receive the ESOP benefits. They must work in the company for a specified number of years, and they can only receive benefits when partially or 100% vested.

There are two types of vesting periods for ESOP plans. The employee can choose cliff vesting, which lasts for three years, or graded vesting that lasts six years. With the cliff vesting period, the employee will become 100% vested to receive benefits after three years. If they choose to leave the company before the three years are over, they will not receive any benefits.

The graded vesting option allocates 20% vesting per year. For example, the employee is 0% vested in the first year, 20% in the second, 40% in the third, and so forth. This option becomes fully vested after six years. It’s a suitable alternative for an employee who plans to leave before three years.

The amount of shares allocated to employees depends on compensation. For example, an employee who earns $100,000 per year will accrue more shares than one who makes $10,000 per year. Each participant will receive an annual statement highlighting the number of shares they received that year.

The payment process for an ESOP is different from other forms of employee ownership. The employee can only get a payout for their accrued shares when retiring or voluntarily leaving the company. The company buys the employee’s shares and then begins the holding process again for another staff member.

ESOPs are, in most cases, an exit strategy for founders or owners. They help motivate and retain employees while giving the owner the buyout needed to leave the company.

Employee Participation

The eligibility requirements for an ESOP are more or less similar to those in a qualified retirement plan, for example, a 401(k). For an employee to become a participant, they should be at least 21 years of age and in their first year working in the company. The IRS also allows the employer to set eligibility at two years, but only if the ESOP plan offers immediate vesting.

Employee-Owned Companies Pros and Cons

ESOPs are beneficial to not only employees but also to the company and the existing shareholder. Check out the pros and cons of an employee-owned company:

Pros

• Ability to Borrow Funds

When setting up an ESOP trust, the company can borrow money from financial authorities to purchase stock from the selling shareholder. Such ESOPs are known as leveraged ESOPs. They allow the company to buy more shares than they can afford. Borrowing also enables the company to pay the selling shareholder in full rather than paying gradually over time.

• Tax Advantages

Managing an ESOP comes with certain tax benefits for the company and the selling shareholders. Employee contributions are tax-deductible. The company also pays no taxes on contributions and dividends used to repay ESOP loans. There are also no taxes charged on the accumulated employee ownership shares.

• Attract Talented Candidates

Companies that offer ownership to employees are more attractive to candidates than those that don’t. With an ESOP plan, the employer can easily hire the best candidates in the job market. This form of ownership also helps increase employee retention because it offers your staff a reason to stay and grow with the company.

• Reward Employees

An ESOP plan is an excellent strategy to reward employees for their hard work and the years they’ve served a business. The employee also gets financial gains when leaving or retiring from the company.

• No Upfront Cost

One notable advantage of an ESOP ownership plan is the employee pays no upfront money to buy shares. In the case of stock options, they would have to pay a pre-set share price.

• Employees Get Ownership

An ESOP plan allows employees to acquire ownership. It helps boost staff morale and motivates your team to work harder because they have a stake in the company. Employees are more willing to share ideas and encourage change and innovation since they benefit from the outcome.

Cons

• Employees Might Not Get any Control

Even though employees get ownership, they might not get the right to make decisions or control the company’s direction. Although, that depends on the ESOP plan.

• Expensive to Implement

ESOPs are expensive to set up and manage. The costs are, however, on the employer, not the employee. Leveraged ESOPs are more costly to establish than non-leveraged ESOPs. Here are the costs involved in creating and running an ESOP trust:

1. Setup costs: can be as high as $75,000
2. Administration fees: Roughly $20,000 per year.
3. Bookkeeping: the company has to keep records of each employee’s contribution plan. The cost can range between $2,000 and $5,000.
4. Share purchase: the company may have to buy shares from the selling shareholder.
5. Advisor fees (optional): if the company hires a financial advisor to help structure the ESOP, they will have to pay a fee.

Can an Employee-Owned Company Be Sold?

Yes, it can. The process involved is fairly complex, however. Since employees’ shares are held in an ESOP trust, there needs to ESOP trustee present for the sale to occur. The trustee has a fiduciary responsibility to oversee the sale but should act in the best interest of the employees. He has the final say and should be part of the offer discussions from the beginning.

During the sale process, the trustee has the mandate to determine that:

• The deal is fair from a financial viewpoint.
• Adequate consideration will be received for the shares.

Due to the complexity of the sale process, the trustee is advised to hire an independent financial advisor and seek legal counsel.

Employee-owned Organizations

Here is a list of big and successful companies that are employee-owned:

• WinCo Foods
• Recology
• Penmac Staffing
• Publix Super Markets
• Graybar Electric
• Davey Tree Expert

When Is an ESOP not a Good Ownership Option?

ESOPs are not a good option for large and valuable companies. The company may have to spend a lot of money buying out the departing owner. They might purchase shares from the selling shareholder at a price lower than should be.

Multigenerational and family-owned businesses are also not suitable for ESOP. Most owners may want to keep ownership in the family.

Small companies with little revenue are also not a good fit for ESOP. The setup and administration process might be too costly for the company.

Conclusion

An employee-owned company is one in which employees have partial or 100% ownership of the business. There are many forms of employee ownership, but ESOP is the most common in the US. ESOPs are an excellent buyout strategy for departing owners and founders. They also allow employees to acquire ownership.

When a company wants to transfer ownership through an ESOP, they need to set up an ESOP trust. The vesting period can be three years for cliff vesting or six years for graded vesting. Once an employee becomes vested, they can sell their shares back to the employer for financial gain. The employee should, however, be leaving the business or retiring.

Establishing an ESOP offers many advantages to the employer, employees, and selling shareholders. The employer gets tax benefits while the employee incurs no cost for buying company shares. ESOPs are, however, costly to set up and manage.