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. There are a handful of ESOPs with under 10 employees, and a larger number between 10 and 20, but in most cases at least 15 employees is a reasonable starting point.
The key issues to consider are the costs of the plan relative to the benefits, whether there is successor management, if the company is profitable enough to pay for the costs of buying shares, and whether the company has personnel willing to spend the time to learn about and manage ESOPs.
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.
To set up a plan, you need an attorney and an independent appraisal in all cases. You may want to have a financial advisor help assess feasibility as well. The plan must have a trustee to protect the interests of plan participants. This can be an internal person (but not the seller or people related to the seller). For the most basic services (attorney and appraisal firm), in a non-leveraged transaction (one where you do not have the plan borrow money to buy shares), costs can be as low as $60,000 (in 2017); leveraging will add another $20,000 to $30,000 and up. An outside trustee, which is recommended for the initial transaction but not required, could add another $20,000 to $50,000.
Leveraging adds costs for a number of reasons. 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 to $30,000 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.
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 to $4,000 per year as a base cost, plus $30 to $60 per employee.
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 too high; some 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. This article is aimed a very small companies; larger companies may involve more costs, but costs are usually well outweighed by other benefits if the company is otherwise a good ESOP candidate.
Assessing Costs vs. Benefits
There are several things to consider when trying to figure out if these costs can be justified:
- Do You Have Successor Management? Many small companies have an owner who is essential to the business. Unless you have successor management in place, an ESOP is not likely to work or to get financing.
- Is There Someone Willing and Able to Deal with ESOP Complexities on Staff? ESOPs are complicated. Even if you have an external trustee, you need someone on the staff who will develop sufficient expertise on the topic to make sure that the right information is being provided to employees, appraisers, the trustee and plan administrators. If someone internally acts as a trustee, that requires even more knowledge and more time (a few weeks per year).
- What Are the Alternatives? It will likely cost at least $60,000 to $80,000 (in 2017) 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.
- 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.
- 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 $20,000 per year, and your combined federal-state tax rate is 30%, you should be able to contribute at least about $70,000 a year to offset the cost). Otherwise, you might consider a non-tax qualified plan.
- 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 $270,000 a year [as of 2017]). 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? Note that the "internal" ESOP loan used for this calculation can be extend for a very long time (well over 10 years), so this is usually not an issue.
All of this is not meant to discourage companies form doing ESOPs. The benefits of ESOPs to all parties can be substantial. But you need to go in knowing what is required. 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 if this is worth pursuing further.
The NCEO can provide introductory overview consulting to help you determine if you are a candidate or if another employee ownership approach makes sense. Typically, this involves a 90-120 minute conversation. Contact us for details.