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How Small Is Too Small for an ESOP?

One of the most frequently asked questions the NCEO has received over the last few decades is "Is my company too small to have an ESOP?" There is no simple answer to this, and certainly there are no upper or lower limits per se on the size of a company sponsoring an ESOP. There are, however, some basic guidelines that can help determine when an ESOP is worthwhile.

Calculating the Cost

First, of course, you need to know how much an ESOP will cost. Unfortunately, cost estimates vary widely from one case to another and one consultant to another. There are several components of cost: preparing plan documents and government filings; obtaining a valuation; administration; and, in a leveraged ESOP, loan commitment fees, legal fees for the lender's counsel and loan documents, and, possibly, financial consulting for structuring the transaction.

The cost of drawing up the plan documents and government filings is generally not as much as people think it will be. In a small company transaction, lawyers tell us fees of $10,000 or more are typical. These costs will be somewhat lower if you come well prepared, already understanding the basics of ESOP rules and knowing what you want your plan to do. Most ESOP attorneys have plan documents on word processors. Their fees are more a function of the time they spend with you figuring out what the document should include.

Valuation normally will carry fees in the same range for smaller companies, assuming that there is only one class of stock in the company and no unusual complicating elements. Repeat annual valuations should be about half this fee. It may be possible to obtain an even lower charge in some cases, but it is imperative that costs not be cut by hiring people who do not normally do ESOP work.

Plan administration costs—keeping records, filing reports, sending plan account statements, etc.—depend on the number of employees. There are certain fixed costs, however, so there are some economies of scale for larger firms. A firm of 20 employees might reasonably expect to pay around $2,000 per year as a base cost, plus $30 to $60 per employee.

Where costs become really high is when an ESOP borrows money. The lender usually wants legal opinions from its counsel, charges loan commitment fees, and needs loan documents prepared, not unlike the fees involved in a mortgage transaction. Even in a transaction of several hundred thousand dollars, this could add another $10,000 or more to the costs. If a loan cannot easily be obtained, or if the transaction involves multiple sources of financing, it may be necessary to hire a financial adviser to help structure the deal. These experts often charge a percentage of the transaction costs, typically 1% to 3%, with the percentage a function of the size of the transaction.

All of these estimates should be viewed cautiously. Invariably, when we report costs we receive at least a few calls from people who say we misled people. Some say our estimates are much too high; some say much too low. The truth is that costs vary considerably depending on the nature of the transaction. The costs listed here are "ballpark" numbers for simple transactions.

Assessing Costs vs. Benefits

There are several things to consider when trying to figure out if these costs can be justified:
  1. What Are the Alternatives? It will likely cost $40,000 or more for a leveraged ESOP to buy out part or all of an owner's interest. That may seem exorbitant in, say, a $500,000 sale. But what are the choices? If the company is sold by a business broker, a percentage of the fee will be charged that will at least match that. If a partial interest is for sale, it may be difficult or impossible to find another buyer willing to offer a reasonable price, adequate security, or a satisfactory continuing employment relationship if the seller wants to stay with the company. Employers also may have a strong preference to have employees own the company.
  2. What is Our Tax Bracket? If you are not paying taxes or are in a low tax bracket, some tax advantages may have little application, although the rollover benefits may still be worthwhile to the seller.
  3. How Will Annual Costs Compare to Annual Contributions? The annual fees you pay, including an amortized amount for start-up costs, should be less than the amount of annual contributions you make multiplied by your tax rate (if your costs are $9,000 per year, and your combined federal-state tax rate is 30%, you should be able to contribute at least $30,000 a year). Otherwise, you might consider a non-tax qualified plan.
  4. Is Our Payroll Adequate? Figure out what the eligible payroll of the people actually in your plan will be (exclude pay of people who will not qualify for participation or an individual's pay over $205,000 a year [as of 2004]). Then multiply by 25%. In a leveraged plan, multiply this number times the number of
    years of the loan, and this will give you an estimate of the maximum amount you can borrow. Is this going to be enough of an annual contribution to buy as much stock as you want to make available?

As a rule of thumb, ESOPs work best for companies with over 20 employees, but a little back-of-the-envelope calculating can give you a much better idea.

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