Is an ESOP Right for Your Firm?

As accounting firms consider their futures, some are turning to employee stock ownership plans (ESOPs) as a means to recruit and retain talent. An ESOP is a defined contribution retirement plan in which employees can gain an ownership interest in part or all of the company they work for, often without using their own capital.

“Firms are looking at different ways to move away from the traditional partnership model,” says Aziz El-Tahch, managing director and ESOP & ERISA advisory practice leader at Stout. “An ESOP also offers another option for firms to consider as an alternative to private equity (PE) investment.”

These days, more firms are exploring the ESOP pathway because either senior partners are retiring, they lack the necessary talent who could take over the business, or both.

Tom DeSimone, CPA, director of Prairie Capital Advisors Inc., whose company operates as a partially owned ESOP, says an ESOP is a powerful succession planning tool, as it offers a way to share a company’s value with employees: “Studies show people work harder when they know they have a stake in the company.”

Of course, forming an ESOP is a significant decision for partners, and experts warn it may not be a good fit for every firm. That’s where a feasibility study comes in. A feasibility study can help gather, organize, and analyze all the relevant information needed to determine whether a firm should move forward with an ESOP transaction. More importantly, it helps determine whether an ESOP structure will yield the desired results and is in the best interest of the firm’s employees.

Importantly, a feasibility study will set a reasonable value range of the firm, which is crucial for determining whether it’s worth proceeding with an ESOP transaction.

DETERMINING OBJECTIVES AND GOALS

The first step of a feasibility study is to define the corporate and strategic objectives that’ll determine which capital structure puts the firm in a position to meet those objectives.

Blake Head, managing director and leader of BDO Capital Advisors’ ESOP advisory group division, has been on both sides of the ESOP table—as an advisor and client—since BDO formed an ESOP in August 2023. As an ESOP advisor, he says one of the first things they do with clients is sit down with them to understand their goals.

“We want to know if the goal is about achieving fair market value, earning maximum cash at close, or rewarding employees. A transaction will be structured to achieve those goals,” he says.

DeSimone says client education is key: “Our goal is to bring them up to speed on what an ESOP is, what it might entail, and the potential impacts to the firm. ESOPs are complex and regulated, so we spend time at the front end of the analysis, making sure everyone understands what’s involved.”

Importantly, trade-offs might be necessary, Head adds: “Each stakeholder group might want a different intended outcome, so it’s important to understand everyone’s goals before moving on to the next step.”

TAKING A DEEP DIVE

Once the objectives are agreed upon, a feasibility analysis can delve into various aspects and metrics of a business to determine if becoming an ESOP makes financial sense. The results of the analysis will provide the underpinnings of a proposed structure that’ll be presented to the shareholders.

During this process, an ESOP advisor will:

• Assess historical financial results to understand the firm’s financial history.
• Prepare financial models based on the firm’s projections.
• Determine how the ESOP fits in with other qualified retirement plans in place (e.g., 401(k) plans).
• Determine the estimated ESOP benefit as a percentage of eligible compensation to employees.
• Assess debt capacity and financing options.

From this assessment, selling partners and shareholders can expect to learn information about the:

• Structure of the ESOP. This includes how it’ll be paid for, financed, and paid back over time. “ESOPs tend to have some of the transaction financed by the seller through a promissory note,” DeSimone says. “The promissory note structures how a seller will be paid over time.”
• Demands on capital. This might include other investments, like building a new facility, and would overlay the transaction over standard operating procedures to ensure the two can coexist.
• Impact on employees. “By definition, an ESOP is a retirement plan,” DeSimone explains. “The feasibility study models out a structure to deliver that benefit to employees.”

The final step of a feasibility study is performing a debt capacity analysis and determining whether restructuring needs to happen to achieve certain tax advantages. During this step, all the assumptions agreed upon with management will be layered in to determine the firm’s projected cash flow over the next 10-15 years.

DeSimone says this analysis builds a range of all the variables and creates multiple scenarios: “It helps the sellers understand how to meet their sale objectives and how to negotiate going forward.”

AN ITERATIVE PROCESS

A feasibility study will go through multiple iterations with different assumptions surrounding the ESOP until things begin to coalesce around a transaction all parties can support.

“Like designing a house, you go through several drafts of a design until you settle on how you want your house to look—an ESOP is the same way,” El-Tahch stresses. “Once you agree on the final form from the analysis, you can move forward with your blueprint.”

Additionally, Head says that every ESOP should be customized to achieve an organization’s unique goals: “No two ESOPs should look the same. We might look at four to six different scenarios as we continue to see what aspects appeal to the client and until we get approval from them. Then we have the basis for future negotiations and the execution of the ESOP.”

Even then, Head stresses it doesn’t mean the ESOP will end up exactly in that format: “It’s just a roadmap and basis for where we start negotiations—it’s the guiding light toward the end goal.”

Once the principles of the deal are determined, El-Tahch says it’s important to convey what it looks like economically for the partners, firm, shareholders, and other stakeholders: “We’ll spend as much time as firms want, showing them the economics of a PE transaction, comparing it to the status quo, and then comparing that to an ESOP.”

Generally, a feasibility analysis is done on behalf of the board of directors or officers of the firm, and while shareholders should be making the best decision for the firm itself, experts say an ESOP deal needs to be balanced, or it won’t work.

“We’re trying to provide the full picture from every party’s point of view under these models,” Head says. “Is it a good fit? Is it feasible? Does it work?”

DeSimone says that the trustees’ financial advisor will also do their own feasibility study: “They’ll want to ensure the transaction the trustees enter is fair and that the ESOP structure doesn’t put the firm into a challenging financial situation. This allows the opportunity for the ESOP to provide long-term benefits to the employees.”

DETERMINING WHAT’S FEASIBLE

While an ESOP can be viable for organizations of any size, experts warn the cost of installing a program and other complicating factors might mean it’s not a fit for everyone.

“Before you even begin a feasibility study, work with a competent advisor to discuss what you’re trying to accomplish,” Head advises. “A pre-screening and education from an advisor before you move on to a formal study is a good clearing item.”

Overall, if your firm is thinking about an ESOP, El-Tahch says there’s no downside to performing a feasibility study: “We find that firms are sometimes too quick to dismiss a feasibility study because they think an ESOP is just like any other transaction, but until you see the numbers and understand how it stacks up, you don’t really know if it’ll work for you.”

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