Published Spring 2006 in MHEDA Journal Jim Steiker authored this article, which provides a high-level overview of ESOPs, how they work and how they can benefit multiple stakeholders.

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by James G. Steiker
SELLING IN
Liquidity and succession using an ESOP
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HEDA company Alliance Material Handling Inc. (Jessup, MD) was formed by the merger of three partners
in 2001. In 2004, Hobb Santel, Ted Wolff and Joe
DeFrange were joined by a fourth shareholder: an ESOP trust
created for the benefit of the company’s employees.
The trust was formed under an
Employee Stock Ownership Plan, or
ESOP. The ESOP purchased stock
from the other three shareholders for
fair value using borrowed money.
Santel, Wolfe and DeFrange did not
pay any immediate taxes on their
sale of stock to the ESOP. Alliance
Material Handling will fund the
ESOP using tax-deductible dollars to
repay the borrowed money, and
Alliance employees will gain ownership free and clear under the ESOP
as the loan is repaid.
Business owners, including MHEDA
distributors like Alliance, Modern
Group (Bristol, PA) and others, are
increasingly turning to ESOPs as a
corporate finance tool to provide for
liquidity and succession. For the business owner, an ESOP is a way to create liquidity, preserve company independence, protect wealth, diversify
assets, plan for an orderly and phased
succession, and defer taxes. For employees, an ESOP is a company-funded retirement plan that offers an ownership stake in the company. For the
company, an ESOP is a way to finance ownership transition in a taxfavored transaction. But what exactly
is it?
WHAT AN ESOP IS
ESOPs are tax-qualified retirement
plans created as part of the Employee
Spring 2006
Retirement Security Income Security
Act (ERISA) in 1974. The ESOP concept dates back as early as the 1950s,
when investment banker Louis Kelso
first conceived that businesses nationwide would be stronger and more
profitable if employees of a company
were offered a stake in the company’s
success. According to the nonprofit
National Center for Employee Ownership (www.nceo.org), today there are
more than 11,000 ESOP companies
nationwide covering more than 8.5
million employees.
ESOPs are similar to other retirement plans, such as 401(k) and profit-sharing plans, but they have several distinguishing characteristics.
employer contributions when received, ESOPs can borrow money to
fund the purchase of a block of
employer stock and repay this debt
with future contributions.
Therefore, ESOPs can be used by
business owners to create an internal
market to sell a block of company
stock. The ESOP can purchase all or
a portion of a company’s stock in one
or more transactions, depending on
the goals of the shareholders. For
business owners who want liquidity
and diversification in stages, an ESOP
may be an ideal approach.
The government provides special
tax incentives to spur creation of
ESOPs. For example, companies can
fund the purchase of stock from
shareholders using tax-deductible
dollars. Shareholders generally can
defer capital gains taxes on the sale
of shares to an ESOP if the ESOP
Structured properly, ESOPs provide business
owners with both liquidity and succession at a
controlled pace while simultaneously creating
an employee benefit based largely on the success of the business.
Unlike other plans, which are required by law to diversify their
assets, ESOPs are required to invest
primarily in the stock of the employer company. Also, unlike other retirement plans that generally invest
MHEDA
owns more than 30 percent of outstanding company shares, the company is or becomes a “C” corporation,
and the selling shareholder uses the
proceeds of the transaction to purchase stocks or bonds of any domes81

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tic operating corporation.
Unlike other “S” corporation shareholders, if an ESOP is a shareholder
of a company that is or becomes an
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4. The Trust uses the borrowed
money to purchase all or a portion
of the company stock from the
stockholder.
If You Want Employees to Think and Act Like Owners, Make
Them Owners.
For more information about Employee Stock Ownership Plans,
check out these Web sites:
The ESOP Association www.esopassociation.org
The National Center for Employee Ownership www.nceo.org
Should You Have An Employee Ownership Plan? Corey Rosen
helps you answer that question in his article from Winter 2001.
More ESOP-related tips from MHEDA members Modern Group and
Cisco-Eagle appeared in Fall 2004. Read them again in The
MHEDA Journal Online.
“S” corporation, the ESOP does not
pay taxes on its share of the corporate
income. A company such as Modern
Group, which sponsors an ESOP that
owns 100 percent of company stock,
is effectively tax-free because, as an
“S” corporation, the company pays no
corporate income tax and the ESOP,
as a tax-exempt shareholder, pays no
individual income tax on the corporation’s income.
HOW
AN
The government provides special tax incentives
to spur creation of ESOPs.
ESOP WORKS
The first step in establishing an
ESOP is to analyze your company’s
financial information, revisit your
business plan, and determine what
you want to accomplish with the
ESOP. The goal of this feasibility
analysis, accomplished with or without outside professional help, is an
approximate valuation of the company and an ESOP transaction design
that will meet your goals.
A typical leveraged ESOP transaction works like this:
1. The company establishes an
Employee Stock Ownership Trust.
2. The Company borrows money
from a bank, usually secured by a
security interest in the company’s
assets.
3. The Trust borrows this money
from the company, secured by a
pledge of the stock that it purchases with the money.
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5. The bank may require the shareholder to pledge some of the
money it receives as security for
the bank’s loan to the company.
ESOP transactions are not “name
your own price.” An ESOP must have
success of the business. ESOP companies generally outperform their nonESOP counterparts, measured by productivity and profitability. Participation in an ESOP gives employees a
“piece of the action.”
ESOPs can provide significant tax
and organizational benefits for closely
held companies. ESOPs work particularly well for established and profitable
companies with good potential successor management. The key downsides
of ESOPs are the need to borrow
money for funding the transaction and
the relative complexity of ESOP transactions. Be sure to consult with an
experienced professional when contemplating an ESOP so you are aware
of what will be involved with an initial transaction and beyond. There may
also be ways to use an ESOP transaction to accomplish important company
and shareholder goals that are not
immediately obvious.
If you are looking for an exit strategy that offers fair value for your
an independent appraiser determine
the fair market value of the shares of
company stock to be purchased by
the ESOP and cannot pay more than
fair value for the shares.
Structured properly, ESOPs provide
business owners with both liquidity
and succession at a controlled pace,
while simultaneously creating an employee benefit based largely on the
company ownership, doesn’t require
an immediate sale to a third party,
and rewards the people who have
helped build your business, consider
an ESOP. It may be the right “winwin” strategy for the company, the
shareholders and the employees. Just
ask the shareholders and employeeowners of Alliance!
CONVENTION PRESENTER
“Employee Stock Ownership Plans”
James G. Steiker is president of SES Advisors Inc.,
located in Philadelphia, Pennsylvania, and on the
Web at www.sesadvisors.com.
MHEDA
Spring 2006