Originally published on Benefits Pro

By Joe Rankin

Employee stock ownership plans (ESOP) have been popular ownership transition mechanisms for small-to medium-sized private companies for many years for all manner of reasons.

An ESOP can be used to help a business owner sell all or part of their firm to cash out, it can facilitate management succession and/or it can allow employees to share the profits of their labor.

In addition, they’ve historically been a cost-effective way of achieving those goals, too, typically costing $200,000 to $1,000,000 depending, in part, on the size of the transaction and any underlying complexities.

However, recently more and more clients tell us they’re being pitched services to set up ESOPs with advisor “success fees” that can be $2 million or more. As a general rule, anyone being asked to pay for that type of “success” should be skeptical.

ESOPs facilitate management and employees slowly buying out the existing owners of a business. Beyond succession planning, there are tax reasons why such a mechanism makes sense. Understanding how an ESOP works shows why: The company can make tax-deductible contributions to a trust that then buys stock from the current owners.

The price of the stock is a fair market value, as set by an independent business appraiser retained by the trustees of the ESOP. The transaction may have significant benefits for the owner.  The owner pays less in income taxes because that transaction is taxed at capital gains rates, which is likely lower than income tax rates; depending on the transaction type, a deferral of the proceeds may be available.

On an ongoing basis, an S-corp ESOP reduces taxable income, allowing the company to operate partially or totally income tax free.

Attractive as all that sounds, setting up an ESOP is challenging. Of over 100 potential ESOP-owned companies we’ve worked with in recent years, fewer than 5 percent have closed a transaction.

There are a myriad of hurdles inherent in an ESOP. However, if companies interested in ESOPs gain a better understanding of those hurdles and the costs involved, they’re more likely to reach a positive outcome at a reasonable price.

The complexity of setting up an ESOP is why some vendors offer to undertake these transactions; “success fees” are potential hurdles that certainly need to be understood before entering into any agreement.

Establishing an ESOP requires a laundry list of things to happen and be determined, often simultaneously:

• An initial valuation is made to give a range of fair market values.
• A feasibility review is made of the company’s financial situation to assess the best deal structure, how it will be financed and its implication for corporate structure as well as 401(k) or pension contributions. Feasibility studies cost between $15,000 and $50,000.
• The ESOP’s repurchase liability is determined, assessing the potential cost of buying the shares from the participants and re-contributing those shares to the plan. These studies cost upwards of $50,000.
• How will the company be structured and will the ESOP require a reorganization?
• Once the corporate structure is decided, the company must be valued at fair market value.
• An independent fiduciary performs due diligence and negotiations for plan participants, incurring fees of $50,000 to $150,000.
• Financing, either bank, owner, or alternative financing, must be vetted. (Most financing entities require some owner participation in the financing.)
• Plan documents, summary plan descriptions, government filings, corporate amendments, non-compete agreements and corporate governance rules must be developed, at a cost of $25,000 to $50,000.  Other corporate legal review may also be necessary to effect and ESOP transaction such as the construction and review of purchase agreements and loan agreements.

ESOPs also bring recurring administration annual fees for services such as an annual valuation ($15,000 to $50,000) or an annual company audit ($10,000 to $25,000), administration fees ($10,000 to $40,000), legal fees ($5,000 to $50,000), independent fiduciary fees ($25,000 to $75,000) and a plan audit ($10,000 to $20,000).

On top of that, there are the soft costs such as additional meetings and extra employee communications.

With the complexity, negotiations, and so much paperwork and planning to plough through, it’s little wonder that many companies ultimately decide that an ESOP is not for them. Those that tend to undertake an ESOP and the required diligence tend to be larger, more and consistently profitable companies.

Any company considering an ESOP should be mindful of a number of potential pitfalls not typically mentioned by ESOP promoters:

• Fair market value as determined in an ESOP might be lower than the owner expects because it may not include the strategic value embedded in a company were it sold to an outside buyer or competitor.
• Bank or alternative financing can at times be difficult to obtain and expensive.
• Using an independent fiduciary to eliminate self-dealing concerns can be costly. For example, if management is both the ESOP fiduciary and owner, it can create conflicts and make otherwise routine transactions complicated.
• Governance may also be expensive and cumbersome. And, quarterly participant meetings may be needed.

As challenging as all this might appear at first blush, more than 9,000 American firms, employing more than 15 million workers and valued at more than $1.3 trillion, have undertaken ESOP or similar plans. And 92 percent of those companies are privately held.

As with many things in business, in order to get an ESOP right, it’s more important to get outstanding service from providers than to worry too only about price.

However, paying success or other contingent fees that can amount to millions of dollars more than the other necessary professional services needed for the transaction must be thoroughly vetted, understood, and challenged where the value is not readily apparent.