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Ask Toolkit About ESOPs

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By | October 28, 2011

Dear Toolkit,

Do you think an ESOP is good way to raise capital for a small business?


Just Wondering

Dear Just Wondering,

As you no doubt already know, an Employee Stock Ownership Plan (ESOP) is a qualified retirement benefit plan in which the major investment is made in securities of the employer's company. Whether or not an ESOP is a viable source of equity capital will depend largely on how many employees you have as well as how expensive your lawyer's fee schedule is—since structuring an ESOP is a complex legal challenge of the first order.

In an ESOP, employees can purchase shares of stock in the company by paying cash or by agreeing to reductions from salary or benefits. The employees become part owners of the business and you gain additional funds for other business purposes.

In addition, the company contributes to the ESOP by either making an annual cash contribution to the plan for the purchase of company securities or by directly contributing stock to the plan. Either way, the company's contribution results in the cash price of the stock being returned to the company. The company gets a tax deduction for the ESOP contribution while effectively retaining the cash.

ESOPs may be of further benefit to a company because giving employees a vested interest in the business may promote productivity and a commitment to the long-term success of the company.

However, because an ESOP requires that you have employees and because implementing an ESOP can be expensive and time-consuming, this financing tool may not be possible for many small businesses.

Moreover, you should be aware that plan participants who terminate employment may demand distribution of stock itself, rather than simply the stock's cash value. A closely held business may not want former employees to own stock in the company or to be able to vote as shareholders.

ESOPs are, however, commonly used by business owners seeking to retire from the business. If your small business has grown to the point where you have a fairly large number of employees, an ESOP can provide an excellent way to, in effect, sell your business to your employees because the ESOP provides a ready-made buyer for your stock.

Keep in mind that, because of the complexity involved in establishing and maintaining an ESOP, you will definitely want to consult an attorney and/or accountant right from the get-go.

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