I recently spoke with Corey Rosen, founder of the National Center for Employee Ownership (NCEO). NCEO is a nonprofit membership organization that provides practical resources and insight on employee stock ownership plans. Corey has worked directly with family-owned businesses over the years.
What issues have you seen when a family business transitions to the next generation?
When a second generation takes over a family business, it may face some employee engagement issues because many employees will have been hired, and are loyal to, the first generation.
How have you seen these issues addressed?
One way is to sell some of the stock to an Employee Stock Ownership Plan (ESOP). Research shows that companies with ESOPs – especially if they encourage employee involvement in work-level decisions – substantially outperform their competitors. An ESOP is also a highly-tax favored way to share ownership, meaning it provides a second generation a very attractive way to get liquidity for its some of its ownership while retaining control of the company.
What are the financial benefits of an ESOP for a family business?
ESOPs provide the most tax-favored way possible to transfer ownership. Companies set up a trust to acquire shares. The company makes tax-deductible contributions to the trust to buy shares of the seller(s) or it can have the trust borrow money from a bank or the sellers themselves to acquire a larger block of shares all at once. So the stock redemption is all pre-tax. Sellers can also defer capital gains if they sell to an ESOP in a C corporation. In an S corporation, they do not get this benefit, but there is no tax on the portion of the profits attributable to the ESOP. Employees have shares allocated to them in the trust; they do not buy them.
What are the most important people benefits of an ESOP?
The most important benefit of an ESOP for a family business is employee engagement. A partial ESOP can be a great tool for gaining employee support with the next generation. The ESOP governance rules are very flexible and, with a few exceptions that rarely arise, allow owners to determine how the company will continue to be run. Owners often stay on in some capacity even after they have sold all their shares.
Are there any other considerations?
Companies need to evaluate the costs of setting up an ESOP, whether they can live with the rules, and whether they have the financing to make any share purchases practical. ESOPs work best in companies that place a strong emphasis on treating employees well and valuing their input. ESOPs cannot be used to give ownership just to specific people; they must include all full-time employees who have worked at least one year.
More information about the National Center for Employee Ownership can be found at www.nceo.org.