Opening an employee stock ownership plan (ESOP) may not be easy, but it should be exciting. ESOPs are a popular way for companies to provide their employees with ownership in the company. An ESOP is a qualified retirement plan that invests primarily in employer stock, providing employees with an opportunity to own a stake in the company they work for. ESOPs offer numerous benefits to both companies and employees, including tax benefits, increased employee engagement, and succession planning.
However, funding an ESOP can be challenging, as it requires a significant amount of capital. There are various funding options available to companies that are considering an ESOP, including internal funding and external financing. And while plans vary from company to company, there are general ESOP funding rules to follow. ESOP funding rules are designed to assure the plans benefit employees fairly and broadly.
To determine your best ESOP funding option, conduct a feasibility study. Feasibility studies can be full-blown analyses by consultants or simple in-house projections, but they should assess whether an ESOP is, well, feasible for your organization. An outside consultant is best equipped to give you an accurate picture of what you’re signing on for. They will utilize market research, financial forecasts, and anecdotal evidence to make their recommendations, so you should find a professional you trust.
ESOP Funding Options
If a feasibility study concurs that an ESOP is the right path forward, you can move on to your funding concerns. ESOPs can be funded in many ways.
1. Self-Funded
ESOPs can be funded by the company directly. First, the company can simply contribute shares to the ESOP. They can do this by issuing more shares or by contributing those that are outstanding. Alternatively, the company can allocate liquid assets to the trust – typically cash – so that the ESOP can purchase shares using those reserves.
Contributing cash is a simple funding solution, and employers can deduct their contributions in the plan year they make the payment. Unfortunately, many companies find it difficult to self-fund with cash at the onset. ESOPs are costly at their inception when the plan’s trust incurs start-up costs and builds reserves to support future stock purchases.
2. ESOP Loans
ESOPs can borrow money directly. Banks commonly administer loans to ESOP trusts and hold the purchased shares as collateral. ESOPs can also borrow money from a selling shareholder or a current owner. This “IOU” will sit on the trust’s books until the ESOP repays the loan, after which the purchased shares will be allocated to participant accounts. These types of ESOP loans are known as leveraged ESOP transactions.
3. Business Loans
Some entities find success incurring business debt to help finance their ESOPs. Instead of the ESOP borrowing money directly, the business will borrow money and then lend that money to the ESOP. In these indirect loans, the organization acts as a middleman between the lender and the ESOP. The bank typically holds the purchased shares as collateral, but there are some instances where it holds other business assets as collateral.
ESOP Funding Concerns
Before you can select the best funding method (or combination of funding methods) for your ESOP, work with a professional to gather all relevant information. If you approach a bank on behalf of your company or ESOP, they will want to know your:
- Historical financial performance
- Current cash position
- Succession plans
- Industry threats
- Repurchase expectations
- Current debt amounts
- Anticipated turnover
And most importantly, they will want to see your ESOP plan document to understand the buyout rules, vesting schedules, and timelines.
If you have further questions about your ESOP, ESOP funding rules, or ESOP loan requirements and would like to talk to one of our advisors, contact us today.
