Things Small Business Owners Should Consider Before Setting Up ESOPs

An image of two elderly business owners in Burlington speaking with their business adviser about ESOPs.

As your small business grows, you seek employees as passionate as you for the company. They share your vision of making the business achieve great heights. In fact, some of the early employees are like families. You don’t have a high package to offer, but you can give a share in the company’s growth and profits. If you are a small business owner with a great team and looking to retire 10-15 years from now while maintaining the vision and culture of the company, ESOPs did cross your mind.

A Brief Overview of ESOPs

Employee Stock Ownership Plans (ESOPs) is a plan that gives employees the option to buy stakes in the company at a predetermined price and become part owner. As employees benefit from the company’s success, they are motivated to stay in the company and grow it further.

When you consider selling your business to a third party, there is no guarantee you will find a buyer. And when you do find a buyer, you may or may not qualify for long-term capital gain exemption. But with ESOPs, you have a ready buyer. You can sell your shares to the ESOP pool for cash, getting full control of your retirement. Even your employees who helped you through the ups and downs can get similar benefits.

Is ESOP Right for Your Business?

Even though ESOPs might look good on paper, they may not be a good option when implemented, given the significant costs a business must incur to set up the plan. Hence, one question that haunts all small business owners is whether there are enough employees to consider such an expensive option.

The law has not put any minimum threshold on the company size or employee count to set up ESOPs. You must think of ESOPs more practically, looking at your business needs.

Consider the Cost of Setting up an ESOP

The first thing to look for is cost. ESOPs are expensive to manage. The cost differs from company to company, and the complexity of the ESOPs. Setting up the most basic ESOP includes costs for planning and documentation, regulatory filing, and legal and administrative. Once the ESOPs are in place, you will have to get your business valuation done annually, pay for trustee services, and maintain funds to repurchase shares in the future if an employee leaves. And if the company buys back shares using leverage, financing costs will be included.

All these costs make a small business owner consider if ESOPs are worth the effort for fewer than 10-12 employees.

Consider the Cost-Benefit Analysis of an ESOP

Looking at cost in isolation is wrong. Look at the cost from the lens of the benefit it brings. If your $100,000 profit converts into a $1 million in a few years, you won’t mind sharing a small percentage of this additional profit with the employees who made it happen. Sharing the success will motivate the employees to give better results and multiply profits.

There are also tax benefits of ESOPs. You can sit with a professional accountant and determine’ the costs and tax savings ESOPs can bring. Other than financial implications, if employee retention and participation are a concern, ESOPs are an effective solution. Hence, many tech startups use ESOPs to retain the company’s brains.

Is Your Business Suitable for ESOPs?

Just setting up ESOPs is not enough. Top employees should desire it and be a good enough motivation to attract the talent you want. For ESOPs to be attractive, the company should be profitable, have growing EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), minimal debt, a strong growth outlook, and regular cash flow. Look at your company from an investor perspective. Would you consider owning your company shares a great investment?

Successful ESOPs have strong participation at all levels of the organization. And the management is willing to relinquish control and welcome employee contribution.

Is Selling the Company to Employees Your Exit Strategy?

The final thing you should consider is how you see your business towards retirement. Do you want to liquidate it, sell it to someone, preserve the culture and let your business outlive you, or give the ownership to family or employees?

What if your children are uninterested in the business or you don’t have a rightful heir? In such instances, giving ownership to employees is beneficial for the company as they have lived through its culture.

Summing it up, ask yourself the following questions when considering setting up ESOPs.

  • Does your company earn a minimum EBITDA for an ESOP to be feasible?
  • How will the ESOP impact existing business owners?
  • How would your company justify the costs of the ESOP transaction and maintenance?
  • Have you considered other incentive and succession plans?

Contact Edelkoort Smethurst CPAs LLP in Burlington to Help You with Strategic Business Decisions Like ESOPs

A professional accountant and business consultant can help you conduct an ESOP feasibility study to understand if it is the right option for you. The experts can help you understand other cost-efficient alternatives that offer similar outcomes. At Edelkoort Smethurst CPAs LLP, our accountants and business consultants can provide services such as business reviews and business exit strategies. To learn more about how Edelkoort Smethurst CPAs LLP can provide you with the best accounting and consultation, contact us online or by telephone at 905-517-2297.