6 Best Practices to Set Up an ESOP for Your Business

by Creating Change Mag
6 Best Practices to Set Up an ESOP for Your Business

Employee retention, for both startups and established businesses, is more important than ever. More and more employees are leaving roles to join companies that offer greater flexibility, increased benefits, higher pay, or even a more mission-driven culture. All of these benefits are rooted in the need for employees to feel valued and believe that the company’s success will lead to their success.

Now, did you know that you can actually create a benefit plan that gives your employees ownership interest in your business? Directly connecting their contributions to the success of your business to additional compensation.

Let’s explore how you can introduce this type of employee incentive and better attract, reward, and retain employees by creating an ESOP for your business.

What is an ESOP?

An ESOP, or an employee stock ownership plan, is a type of compensation plan that allows employees to acquire and own stock in your company. This is especially pertinent for startups, who want to foster company & employee growth, but cannot provide high salaries to staff.

By using employee stock ownership plans, businesses can provide a stable value and increase the wealth of all stakeholders. As part of this plan, employees are often encouraged to learn more about the business and cultivate their managerial and entrepreneurial skills. However, it’s important to remember that these plans have to be made in the best interest of all parties

Benefits of having an ESOP in your business

When used correctly, an ESOP is a great way to build a culture of trust and respect between employees and company management. Since everyone benefits from the company’s financial growth, it often leads to increased productivity, efficiency, and even cash flow

There are also tax benefits worth considering, such as:

  • Deductible contributions of up to 25% of the pay for participants.
  • Tax deductible payments of up to 25% on principal payments. 
  • Federal income tax-free earnings until employees take distributions.
  • Ability to roll the money into an IRA or other qualified plans.

How to determine if an ESOP is right for your business

An ESOP has its benefits, but it’s important to know whether it is the right fit for your company. Here are a few things to consider before implementing:

How do you want to reward employees? 

Having an ESOP is a great way to reward employees who have contributed to your company’s success. However, is this an attractive benefit for your industry? Are there other benefits that your employees want more?

Is your business profitable? 

From a tax perspective, having an ESOP means you are paying taxes on earnings. If you lack profitability, you may find that there are objections to stock purchases. 

Do you want to sell to your employees?

Business owners can sell company stock to employees as part of their exit strategy

When an ESOP is not a good idea for your business

Depending on the circumstances, having an ESOP may not be a good idea for your business. ESOPs are complex and have many compliance obligations. Here are some factors that make an ESOP a disadvantage for your business:

Only C- or S-corporations can use an ESOP

An ESOP is not allowed in partnerships or in most professional corporations. Make sure your company is the right type of business before you consider an ESOP.

Major future expenses can be affected by an employee’s departure

If an employee with an ESOP decides to leave a company, that company has to repurchase their shares. This can become a huge expense or loss for the company if not accounted for.

Setting up an ESOP is expensive 

Even if you set up a simple plan, setting it up is a costly task. If you don’t have the financial resources to set up an ESOP for your employee, it’s better not to consider it.

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6 steps to start an ESOP for your business

If you decide that an ESOP makes sense for your business, be sure to work through the following steps to set it up.

1. Connect with a financial advisor 

Before you officially start, it’s worth consulting a professional to get in-depth assistance when setting up an ESOP. They will be able to provide advice on the taxation, legalities, and organizational procedures involved in the process. Before hiring an advisor, be sure to look into their years of service, legal fees, and track record in successfully establishing growth-oriented ESOPs.

2. Establish how your ESOP works 

In this step, you need to figure out what your requirements and structure will be in order to get the best plan. It is necessary to have a transparent ESOP plan that everyone can understand and trust. This will ensure that your business and employees receive all of the perceived benefits.

You need to decide what kind of plan you want, how much stock you want to buy, how many employees will be included in the plan, and what kind of vesting schedule there will be. 

3. Consider changes in ownership 

Your business will undergo a change in ownership when you set up an ESOP. Therefore, every business owner needs to know how the company ownership structure will change and whether they will be affected by this process or not.

It is important to remember that the transfer of control should happen gradually. You should not let the control pass from one person to another in a matter of weeks or months. For example, plan to set aside 10-15% of the total ownership into an ESOP pool, and allocate the options over a 3 to 4-year vesting period.

4. Get a 409a valuation 

You will need to get a 409a valuation of stock options to determine the fair market value for the plan. This will ensure that your ESOP is legally viable and accurately reflects the value of your business. If you’re working with an advisor, they will likely have a recommended method, and possibly even be able to conduct the valuation.

Keep in mind that you can always conduct a refresh later on if necessary.

5. Get board approval 

To legally establish an ESOP, you need the approval and cooperation of any board members. Even if you don’t have an officially established board of directors, anyone who has an established financial interest in your business will need to be consulted. Aside from the legal implications, their input and expertise can also ensure that your ESOP is set up effectively fit your business.

6. Prepare documents and finalize ESOP 

To finalize your ESOP you need to prepare and compile all necessary documentation. This includes ESOP plan agreements and option grant agreements with all option holders. If needed, you may also amend the company articles within your business plan to cover your ESOP.

For a full rundown of all ESOP requirements, it’s best to consult with your advisor. To help guide its implementation, check out this documentation from the IRS

Execute and track your ESOP

After finalizing your plan and having your documents approved it is time to put it into action. You need to follow the plan you established and track how the stock is being issued. You need to be sure that you have all the legalities and taxation details in order to get the best outcome. 

Remember, an ESOP is not the best option for every business. If you’re a startup looking to fuel growth and drive employee engagement, it can be an excellent option. However, you’ll need to consider how it will truly impact your business, what it will take to implement, and how you’ll maintain it over time. There may also be other benefit options that are a better fit.

Don’t rush into deciding on using an ESOP. Take your time, explore the possibilities, and seek out expert guidance. No matter if you decide to start an ESOP or not, you’ll better understand its use and what other options are available to grow your business.

AvatarColin McCrea

Colin is the CVA of Eqvista, leading in the valuation section of private companies, and specializing in the space around company valuation, investments, VC funding, seed funding, cap table, equity management.

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