Are ESOPs a good fit for business and professional services (BPS) companies?

ARTICLE | November 17, 2023

Authored by RSM US LLP

Executive summary: ESOPs in the BPS industry

Employee stock ownership plans (ESOPs) can be advantageous for a variety of entity types and industries for various reasons, but their success ultimately depends on several factors, including company culture, messaging and a company’s ownership goals. In particular, there has been increased interest in ESOPs among the business and professional services (BPS) industry (e.g., companies providing marketing, architectural, engineering, legal, accounting and consulting services, among others).

According to the National Center for Employee Ownership (NCEO), BPS companies represent approximately 21% of employers that have ESOPs. The increased attention on ESOPs reflects their universal benefits to the primary stakeholders of the business: the employees, shareholders and the company itself.

ESOPs can provide market differentiation and drive increased growth through employee engagement, while providing enhanced retirement benefits to employees at no cost or current tax impact to them. Selling shareholders may also be more willing to transition ownership that has minimal impact on the company’s day-to-day operations, may be more tax advantageous than other ownership transfers and preserves the legacy of the business.

From the company’s perspective, an ESOP often requires adding debt and adds some administrative complexity but also comes with tax deductions and an increased total rewards package for the workforce.

In this article, we will explore how company culture, messaging and ownership goals can manifest as an opportunity or a challenge for BPS companies that either currently have, or are considering, an ESOP. 

Company culture

Many BPS companies are structured as partnerships, and the traditional path to ownership in a BPS company has historically been that ownership is granted to management-level employees who are rewarded for their significant contributions to the company. Ownership is a reward for their service and commitment, allowing them to share in the company’s growth and profits. It also further incentivizes future levels of high service.

This culture can be a challenge or an opportunity for a BPS firm implementing an ESOP. For an ESOP structure to cultivate successfully, the existing owners of the company need to be agreeable to sharing their ownership and actively fostering a culture of ownership among a broader group of employees. Company culture takes time to form and change, so this requires ongoing commitment to driving a culture of employee ownership within the company.

Messaging

Closely tied to fostering an ownership culture, messaging plays a key role in the success of an ESOP. When implementing an ESOP, a company may need to consider how to brand and communicate the change to employees. For example, what is the vision and purpose of the ESOP? How does it work? What does it mean for the employees at all levels? This initial messaging could involve specific employee trainings, firmwide meetings or other commonly used messaging avenues.

Messaging, like culture, requires a thoughtful and ongoing effort to provide clear and consistent vision that is aligned to the culture being implemented. This may involve sharing regular financial updates about the company, growth opportunities, obstacles to growth or other information with the broader employee population; however, this is at the company’s discretion.

It may also require consideration for how to treat employees like owners so that they can tangibly connect how their role at the company is tied to their ownership and the broader ESOP vision. This connection can increase retention, boost employee morale and drive engagement.

Ownership goals

It may go without saying, but a company’s compensation philosophy needs to be aligned and supportive of implementing the ESOP. There are several reasons why an ESOP may or may not align with a company’s ownership goals.

1. Selling to an ESOP may be perceived as existing owners giving up control of the business.

Giving up some company ownership is not always synonymous with losing control of the business. First, an ESOP can own any percentage of the company stock, so it is possible for existing owners to retain control through continuing to hold a majority of the shares.

Second, control of company operations and control of voting matters are separate. Ownership will govern voting rights, and a trustee will be responsible for the ESOP’s shares in most voting matters (exceptions do exist for large transactions, such as mergers or liquidations, which require employee participants in the ESOP to vote).

However, day-to-day operational control of the company remains with the management team and the board of directors, similar to any other corporate governance situation. For more on governance structure, read: Who controls an ESOP-owned company?

2. Having an ESOP could be seen as limiting the company’s future while stunting it with large annual costs.

If the ESOP benefit is valuable and communicated properly to employees, it can actually increase company performance through employee productivity and loyalty.

In addition, while the ESOP is a shareholder with voting rights, the trustee’s duty is to vote the shares in the best interest of participants’ retirement account values so the same exit opportunities remain available to the company in the future.

Also, the trustee has an obligation to explore those opportunities if they are in the best interest of participants’ accounts. Therefore, the company can still be sold to an outside party in the future or participate in any transaction that it could have prior to the ESOP; it’s just that the ESOP trustee will be a party at the table in the future.

ESOPs do have costs. In the early stages, the company will incur costs to evaluate plan feasibility, hire a trustee, finance the stock purchase, value the stock and get advice from service providers (likely accountants, attorneys and potentially other consultants) on the transaction, as well as the cost for all of the transaction’s legal documentation. Annual costs include trustee fees, plan administration, a valuation and potentially a financial statement audit for the ESOP.

These costs are not necessarily prohibitive, but they must be weighed with the benefits the ESOP will provide. One step that should be taken in the early stages is to estimate the costs so the company has an approximate idea of the cashflow that will be necessary to setup and operate the ESOP.

Depending on how the ESOP is structured and company performance, it is possible that tax benefits may even outweigh the costs of the ESOP over the life of the plan. For C corporations, these tax benefits include tax deductions for cash contributions or dividends made to the ESOP. For S corporations, the tax benefit is the opportunity to avoid federal income tax on S corporation earnings that flow to the ESOP, a tax-exempt trust.

3. Implementing an ESOP could be perceived as placing large amounts of debt on employees and the company.

Most ESOP transactions result in the company incurring debt to finance the transaction, because essentially, the company is buying its own stock and transferring that stock to employees as part of their retirement benefit.

While the company may incur debt, that debt is not passed on to employees directly because they are allocated shares of the company, not the company’s debt. The value of the stock allocated to employees in their ESOP accounts will be affected by the debt on the company’s balance sheet because liabilities reduce the value of equity and, thus, the value of their shares.

Companies must provide employees an annual statement that shows the number of shares in their account and the net value per share, but as the debt is at the corporation itself, employees do not have direct liability or owe any money to the company if they leave before the debt is repaid.

From the company’s perspective, even though they may incur debt in an ESOP transaction, their increased debt is weighed against the tax benefits from sponsoring the ESOP (described above in No. 2).

4. An ESOP creates a market for a company’s stock so that it does not need to sell to an outside buyer, such as a competitor, and can provide advantageous tax benefits to the selling shareholders.

When owners are interested in selling their stock, or other factors are causing a shift in historical ownership structures, consider how an ESOP compares to other ownership transition methods. One advantage of an ESOP is that it can create a more readily available market for the stock in a closely held company, where interested and able buyers may not be abundant.

Another interest of the owner may be not to disrupt the current workforce through an ownership transfer. By transferring ownership to the employees, there may be a smaller likelihood of the company operations, management, or overall dynamics changing as compared to the unknowns an outside buyer may bring.

Also, one valuable potential benefit of selling stock to an ESOP is a unique tax deferral option available to C corporation shareholders. Tax on the sale of stock to an ESOP that owns at least 30% of a C corporation may be deferred if the proceeds are reinvested in qualifying replacement securities, among other requirements. For further explanation of the tax deferral, read: Tax deferral on the sale of stock to employee stock ownership plans

Takeaway

Whether an ESOP is a good fit for a BPS company is contingent on a number of factors, but it is certainly viable for an ESOP to augment a BPS company’s culture and operations. With the proper intentionality and a framework in place, BPS companies can reap the benefits of employee retention, morale and engagement that drive the organization’s growth.