Debunking Common Myths and Misconceptions about ESOPs
Employee Stock Ownership Plans (ESOPs) are an attractive option beneficial to both the company and its employees. ESOPs offer a substantial gain in wealth and benefit, increased job security and work satisfaction to the employees, and a means to sell company stock, lower employee turnover and retain the talent pool for the company. However, business owners are quick to dismiss ESOPs as a succession planning option or an exit strategy based on perceptions arising from incorrect information or lack of technical knowledge. This article will dispel some of the common myths and misconceptions surrounding ESOPs discussed below:
1. ESOPs result in a loss of control in executive decision making
The corporate governance structure in an ESOP company does not differ from a non-ESOP-owned company; the control over day-to-day operations is not inter-linked with the ownership in ESOP-owned companies. The company’s corporate bylaws and ESOP plan documents determine the administration and control over such operations. Even though the ESOPs are effective in a company with an open-book management culture, it is not compulsory. The employees do not have the right to access confidential information or make management decisions simply because of the ESOPs. Furthermore, as part of a planned business succession strategy, business owners may sell ownership to the ESOP in stages rather than all at once. As a result, during the owner’s tenure at the company, the voting control of the business is maintained.
2. ESOPs are essentially beneficial to the employees
ESOPs are beneficial to both the company and the employees, as they satisfy a wide range of corporate motives and provide the company with tax benefits. ESOPs are a corporate finance tool used as an alternative to a sale or merger; to create liquidity and diversify investments for the owners of privately-held businesses. In most cases, the main objective is to create an in-house market for the existing shareholders rather than create another option for employee benefits. Companies in India and abroad utilize ESOPs to reward and retain their employees and ensure that all their employees work towards improving the performance and profitability of the company. ESOPs also allow lower employee turnover and retention of the company’s talent pool. Therefore, ESOPs are not just beneficial to the employees, but are also beneficial to the company.
3. ESOPs are costly to implement and manage
The cost of implementing an ESOP compared to other succession planning alternatives is much lower, where brokerage, legal, and accounting fees typically are considerably high. In many cases, third-party sales with an investment banking firm or a broker charge involve a percentage of the sale going to them as ‘commission. This amount exceeds the cost of administering the ESOP plan, fixed on an hourly or fixed fee basis. In addition, approximately 68% of Indian listed companies and 29% of unlisted companies, give ESOPs to their employee which amount to a one-time cost to the company. The taxation laws state that if an employee holds shares in a listed company for more than a year, the capital gains are tax-free, therefore, Indian employees exercise the option early with 90% of them doing it within 2 years.
4. ESOPs are only for large companies
The profitability of the company is a more significant factor than the size of the company. In many cases, ESOPs have just 12 to 15 employees with less than $1 MM in annual revenue. The minimum requirement is that the company should be large enough to generate a profit that supports the maintenance of ESOP implementation annually. For example, in the USA, the ESOP Association reports that 71% of its members are companies with less than 250 employees, and the average member has annual sales of $20 to $50 million.
5. ESOPs make it more difficult to sell the business to a third party in the future
There is no minimum percentage of company stock to be set aside for the ESOP; the owners may sell any amount to the ESOP initially or in several stages over time. Therefore, an ESOP is just one additional shareholder of the company. The buyer does not generally differentiate based on the number of shareholders or the division of shares. However, one instance where having an ESOP makes it complicated to sell the business to a third party is when an ESOP sells its portion of the stock to a third party. In such a situation, the ESOP must receive the entirety in cash or stock, and it cannot receive a promissory note for any part of the purchase price. Consequently, in case the purchaser plans to use a promissory note for any part of the purchase price, then the remaining shareholders will have to receive a higher proportion of seller notes.
Although an ESOP is not the right fit for each company, it can be a unique fit for many companies. The key considerations for the effective implementation of ESOPs in a company are: (a) steady financial performance, (b) solid management team, (c) debt capacity, (d) stable employee base, and (e) a willingness to transition a portion of the company to ESOPs, whether small or significant. With these key considerations in place, the implementation of ESOPs can be done successfully in a company. The decision to administer and implement ESOPs within a company is a critical one, therefore, it is necessary to know the relevant facts and have accurate information before making such a decision.