Employee Stock Ownership Plans (ESOPs) bring numerous advantages to companies in all industries. The benefits may be even more significant for Architectural and Engineering (A/E) firms, for which ESOPs are often a good fit.
ESOPs’ benefits are felt profoundly by two groups within A/E firms: the selling owners and the employees. When both these groups benefit, the entire firm experiences the advantages. Read on for an overview of how ESOPs may be an exceptional fit for A/E firms.
What is an ESOP?
An ESOP is a unique form of a qualified employee retirement plan. In an ESOP transaction, owners sell their ownership interest (company shares) to either the Company (redemption) or to the ESOP Trust. Through integrated transactions, shares are then sold to the ESOP Trust and released over a period of time. The Trust holds the shares for employee benefit, which are allocated to employees over time based on compensation levels. Typically, the longer an employee works for the company, the more substantial their retirement savings become, as they received contributions on an annual basis. The selling owners may choose to sell part of their ownership interest (partial ESOP) or all their ownership interest (to become a 100% ESOP-owned company).
Meeting Seller Objectives
Though A/E firms compete on points of differentiation, many share similar beginnings of being founded by practitioners upon whose name and core principles the firm’s reputation is built. When these founding owners are nearing retirement, their selling objectives often center around maintaining this strong company legacy and taking care of the employees who made the firm successful.
Compared to other exit strategies, such as a sale to a financial or strategic buyer, ESOPs help maintain a company’s reputation and legacy. As the ESOP trust is the new shareholder, there are no conflicting buyer objectives that may jeopardize company culture, values or employee welfare. In this way, and because selling owners typically have a seat on the Board of Directors going forward, the owners can be confident that the values they’ve worked so hard to establish are preserved.
An outside sale typically calls for the selling owner’s immediate, cold-turkey exit. Some A/E owners may seek a more gradual transition from company ownership that allows them to maintain some control or stay involved in operations. With an ESOP, the owner may exit within their own desired timeframe by opting for a partial or multi-stage transaction. A multi-stage transaction involves selling a minority ownership interest to the ESOP trust now, with the remaining shares being sold in one or more later transactions. By cashing out a portion of their ownership now, the owner receives some liquidity while maintaining involvement in the company.
Enhancing Employee Value
One of the strongest differentiators A/E firms can possess is a strong employee base. The quality, tenure, expertise and depth of employees are what many firms consider keys to their success. An ESOP gives A/E firms a unique opportunity to reward their valued employees.
When an ESOP is implemented, employees have an opportunity to build equity in the company and access retirement savings that grow with their seniority. Additionally, an ESOP promotes an ownership-culture where employees are invested in the firm’s long-term success – the more successful the firm, the higher the value of the company stock, and the more the employees’ retirement savings will grow. For employees who value the company culture and core principles of the founding owners, the ESOP ensures a continuation – employees don’t have to endure the potential culture shift or mismatched objectives that may come with an outside sale.
Company Success: Where Seller Objectives and Employee Value Meet
When implemented properly, an ESOP not only benefits selling owners and employees, but creates a sustainable employee-owned firm with advantages in tax, recruiting, and operations that may enable the A/E firm to out-perform competitors.
The tax benefits of an ESOP are significant. For ESOPs which have S-Corporation status, the loans used to fund the ESOP transaction can be repaid with pre-tax dollars, essentially making the cost of the transaction tax-deductible. Additionally, S-Corporations may pass through income to the ESOP Trust. ESOP Trusts are tax-exempt entities, meaning the percentage of stock owned by the ESOP Trust is exempt from federal income tax. So, depending on the amount of stock the ESOP Trust owns, an S-Corporation ESOP could be exempt from up to 100% of federal income tax.
Meanwhile, C-Corporation ESOPs are not without their tax benefits. C-Corporation ESOPs can elect Section 1042 of the Internal Revenue Code, which allows the selling shareholders to take advantage of the tax-free rollover. Read more on Section 1042 here.
With the specialized knowledge and training required, many firms in the A/E industry face a shortage of qualified talent, creating a highly competitive recruiting environment. An ESOP could be the edge the company needs for recruiting, as the retirement savings and employee-owned benefits the ESOP provides are attractive to candidates. An ESOP also promotes employee retention. A/E firms may face competitors who attempt to poach top talent with higher salary offers. With an ESOP, employees who have long-term vested benefits may experience a large switching cost – if they leave, they risk losing their unvested shares.
Finally, research shows that ESOPs have the potential to improve the firm’s overall performance and influence long-term outcomes. One of the most significant studies to date, performed by Drs. Blasi and Kruse of Rutgers University, found that ESOPs improved performance (increased sales, employment and sales per employee) over what would be expected without an ESOP. Other research emphasizes the ESOP’s ability to improve the firm’s odds of survival amid economic downfall – view our recent article for more on this.
Helping You Get There
If you have questions about exit strategies, employee benefit plans or other financial concerns of your A/E firm, Boulay is here to help. We have the relevant, industry-specific experience that will help you get there, as we currently serve over 150 professional service clients including numerous A/E firms. To learn more, click here to contact Boulay’s ESOP leader, Dan Markowitz, today.