For business owners considering their exit strategy options, it can be smart to take a little time digging into the details — especially when it comes to similar-sounding alternatives like employee stock ownership plans (ESOPs) and employee ownership trusts (EOTs).
For all their similarities, ESOPs and EOTs have important differences that can play out as pros and cons to a selling business owner, the company itself, and the employees over the long term.
As you research options, you may consider the relative longer-term benefits to the company of a profit sharing arrangement versus a qualified retirement plan, for example. While profit sharing may involve less risk and fewer regulatory requirements, your business might reap greater recruiting and retention benefits by offering a retirement plan employees don’t have to pay into.
Ultimately, every business owner’s employee ownership decision is unique. Your choice of exit strategy will be influenced by your financial needs and expectations, your retirement horizon, your succession plan, your values, and much more.
EOTs, ESOPs, and ESOTs: Know Your Acronyms
It can be confusing to get caught up in the acronyms involved, too. Case in point: What is an ESOT?
Both ESOPs and EOTs involve establishing a trust, which purchases the seller’s interest in the company. In ESOPs and EOTs, the trust becomes the direct owner of the business and acts on behalf of employees, who are considered beneficial owners. In an ESOP, the trust is referred to as an employee stock ownership trust, or ESOT — not to be confused with an EOT.
Another similarity between ESOPs and EOTs is flexibility in structuring the sale. In both cases, the selling owner can choose to sell all or some of their interest in the company, incrementally or at once, and the seller can finance the sale with notes to receive their payout of principal and interest over time, if desired. In fact, this is the typical option in EOTs, whereas many ESOPs involve borrowing cash from a lender (as well as seller notes, in many cases).
An EOT is Not a Qualified Retirement Plan
An ESOP, on the other hand, is a qualified retirement plan. That means an ESOP is subject to the Employee Retirement Income Security Act of 1974 (ERISA) … and that translates to regulatory requirements that can be complex and call for professional third-party administration and other services.
What is an EOT, then? An EOT company is held in trust for the benefit of its employees, and EOT distributions are paid as profit-sharing cash bonuses or tax-deductible contributions to employees’ 401(k) accounts. Unlike an ESOP, an EOT doesn’t allocate shares to employees — and therefore, it’s not obligated to repurchase shares when employees depart. That eliminates the financial obligation of stock repurchases, which an ESOP has to plan and account for.
Because an EOT is not regulated under ERISA, but rather the trust laws of its respective state, requirements for documentation, regulatory filings, and other compliance issues are far fewer. This also means that it typically costs less to implement an EOT, and a business that may be too small to meet ESOP nondiscrimination requirements could more easily become an EOT company.
But it’s also important to keep in mind that “qualified” stands for “tax-qualified,” which points to the significant tax advantages an ESOP can offer. Whether the ESOP-owned company is a C corporation eligible for significant tax deductions or a 100% ESOP-owned S corporation that’s exempt from federal corporate income tax, an ESOP’s tax-qualified status helps support healthy company cash flow that can help a business grow well into the future.
Which is Better, ESOP or EOT?
The answer to that question depends on various factors, including (but certainly not limited to) company size and relative value, seller objectives, business growth goals, and much more. Both ESOPs and EOTs create opportunities for business owners to sell the business without giving up their leadership position. Both options create opportunities for owners to recognize and reward the contributions of their employees to the company’s profitability and success. And the deferred payout of an ESOP as a retirement benefit can be especially appealing as a reward for long-term employee loyalty that can help recruit high quality candidates and reduce turnover.
If you’re investigating your exit strategy and succession planning options, you’ll want to download our guide detailing the pros and cons of third-party sales, mergers and acquisitions, ESOPs, and more. Just click the link below to claim your free copy today.