A business owner could be exploring exit strategies for any number of reasons, typically retirement, liquidity needs, or succession and continuity planning.
Regardless of motivation, making a choice means looking closely at options that have similar names and acronyms – case in point, Employee Ownership Trusts (EOTs) and Employee Stock Ownership Plans (ESOPs).
Selling to ESOPs or EOTs involve employee ownership, however their structures, tax rules, risks, and advantages impact sellers, the company, and employees differently.
As such, having a solid grasp on the finer points of EOTs and ESOPs is integral to choosing the exit strategy that best aligns with your business, personal, and employee ownership goals.
The Definitions Behind the Acronyms
It can be confusing and easy to get caught up in the acronyms. Let’s start with a brief definition of each exit strategy.
Employee Stock Ownership Plan (ESOP)
What is it? An ERISA-regulated, tax-qualified retirement plan in which a company sets up an Employee Stock Ownership Trust (ESOT) to purchase company shares and hold it for employees. Shares are allocated to individual employee accounts over time, and participants receive the value of those shares—typically in cash—when they retire or leave the company.
Employee Ownership Trust (EOT)
What is it? A perpetual trust that acquires and holds a controlling interest in a company on behalf of all employees. Instead of issuing individual stock accounts, the trust retains the shares indefinitely and distributes company profits to employees as cash bonuses or tax-deductible profit-sharing payments into their 401(k) accounts.
ESOP vs. EOT: Overview of Similarities
- ESOPs and EOTs both establish a trust which purchases the seller’s interest in the company, becomes the direct owner of the business, and acts on behalf of employees (referred to as beneficial owners)
- ESOPs and EOTs provide flexibility in structuring the sale whereby the seller can choose to sell all or some of their interest in the company, and finance the sale with notes to receive principal and interest payouts over time (common with EOTs), or borrow cash from a lender, potentially in combination with seller notes (common with ESOPs)
- ESOPs and EOTs allow an owner to maintain their leadership position after the sale, if desired
- ESOPs and EOTs create opportunities for owners to recognize employees’ contributions to the company’s profitability and success, with the ESOP’s deferred retirement benefit payout an appealing reward for long-term employee loyalty, and to help recruit top talent and reduce turnover
ESOP vs. EOT: Overview of Differences
- ESOPs are qualified retirement plans, subject to the complex regulatory requirements of the Employee Retirement Income Security Act of 1974 (ERISA) that may call for professional third-party administration and other services. It’s noteworthy that ESOPs are tax-qualified plans, commonly meaning substantial tax deductions for C corporations and federal and state corporate income tax exemption for S corporations, both of which help support healthy company cash flow and growth well into the future
- EOTs are subject to the trust laws of their respective states instead of ERISA, which typically means far fewer parameters around documentation, regulatory filings, and other compliance requirements – reducing plan complexity and often the costs related to implementation, making EOTs attractive to businesses that may be too small to meet ESOP nondiscrimination requirements
- ESOPs allocate shares to employees, creating a legally binding financial obligation to repurchase shares and consistently plan for sustainable repurchase obligations
- EOTs do not allocate shares to employees, instead distributing profits to employees as cash bonuses or profit-sharing payments, thereby eliminating the obligation to repurchase shares and related ongoing financial accountability
Which is Better, ESOP or EOT?
The answer to this question depends on various factors, including (but not limited to):
- Company size
- Relative value
- Seller objectives
- Business growth goals
Undoubtedly, there is a lot to consider when weighing exit strategy and succession plan options. Reach out to the ESOP Partners experts to schedule a consultation, and download Your Ultimate Guide to Business Exit Strategies for easy-reference information any time.
