ESOP Formation

Setting Up an ESOP

Written by Stefan Martinovic for Gaebler Ventures

Setting up an ESOP isn't a new concept but Sam Zell's recent success in buying the Chicago Tribune has many of us wondering -- could we too benefit from an ESOP?

Employee Stock Ownership Programs, or ESOPs, are a type of employee trust and represent a way of transforming your business into an employee-owned company while maintaining managerial control.

Setting Up an ESOP

The ESOP structure is a unique benefit to offer to employees, and is an effective way of giving every employee of your company a share of equity ownership in the business.

Not only does this show employees that you value them by compensating them, but it also gives them a vested interest in the performance of the company, spurring them to perform their work with the best interests of the company in mind.

Additionally, the establishment of an ESOP provides substantial tax benefits, which vary with regions and different businesses.

If you decide an ESOP would benefit your business, there are several steps that you should take to get the job done properly and efficiently.

  • Ensure that you are willing to relinquish sole ownership of your business. If you are adamant about maintaining 100% control over your company, an ESOP plan might not be for you. However, in many cases the vested interest for employees created by the ESOP benefits the business in the long haul. As a principal in the business, you would still reap rewards proportional to your investment in the company.
  • Perform a feasibility study. At this point, you are confident in the ESOP's ability to repay funding. However, there are still other considerations which you must be sure of. It must be determined how much extra cash flow the company has available to dedicate to the ESOP, and whether or not this is the best use for the capital. Being that employees must pay into the ESOP, you must also determine if the company has adequate payroll for ESOP participants to make the plan deductible. Finally, you must determine what the repurchase obligation will be.
  • Conduct a valuation of the company. Before you establish an ESOP, it is important the determine the value of your business to see if the worth of the business is appropriate for setting up the ESOP. If the value of the business is too low, sellers may not be willing to sell. If the values are too high, company employees might not be able to afford to buy into the plan.
  • Hire an ESOP attorney. After completing the first three steps, the plan can now be drafted and submitted to the Internal Revenue Service. An attorney who specializes in ESOPs can assist you in setting the plan up to your exact specifications. It may time several months for the IRS to issue you an official letter of determination, but you may begin making contributions beforehand.
  • Obtaining funding for the plan. The ESOP can borrow money, and banks are generally lenient when it comes to ESOP loans. Additionally, ESOPs may be able to secure funding from bond markets and insurance companies. Company contributions, as well as benefit plans and employee contributions can also be used to fund the plan.
  • Establish a process to operate the plan. A trustee must be chosen to oversee the operations of the plan. The ESOP committee will direct the trustee in his or her actions. The ESOP committee's charge will also include communicating the operations of the plan to employees and persuading them to be involved as owners.

Stefan Martinovic has an extensive body of work across the financial services, manufacturing, and retail industries. He is currently pursuing an MBA in Management and Entrepreneurship at The College of William & Mary.

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