Aside from cost issues, what can make ESOPs not feasible? Several factors need to be considered:
- Is payroll adequate? As explained in the section “ESOP Participation, Allocation, and Vesting Rules and Practices,” there are limits to the dollar amounts that can be contributed to an ESOP each year (generally 25% of pay). If this amount is inadequate to accomplish the objective, most often of buying out an owner or paying off a loan in a reasonable time, an ESOP may not work. Note, however, that it may be possible to expand these limits with the use of dividends. (See the section “Paying Dividends on ESOP Shares.”)
- Are we financially strong enough? If you want to do a leveraged ESOP but cannot get a loan, or you want to buy out an owner but do not foresee future profits to do so, an ESOP may be impractical.
- Is management comfortable making employees owners? If management is not willing to treat people more like owners, an ESOP is rarely a good idea.
- Do you need to change your corporate form? An ESOP can only be set up in a C corporation or an S corporation (although benefits for S corporations are less than for C corporations, and S corporations have only been able to have ESOPs since January 1, 1998). The sections on “Partnerships, Professional Corporations, Limited Liability Companies, and Employee Ownership” and on “S Corporations and ESOPs” explain this further.
- Will cyclicality issues make it difficult for the company to handle debt payments? A company may be in good shape financially but be in a cyclical business, making it difficult to take on much debt. A leveraged ESOP may not make much sense in these cases.
- Is there adequate collateral? A company may have adequate cash flow to service debt but no collateral for a loan. In this case, if there is a seller to the ESOP, the seller may be asked to pledge securities purchased with the profits from the sale to the ESOP as collateral. If this is not possible, the company may not be able to use a leveraged ESOP. One alternative here would be for the seller to finance the transaction, but this raises other issues described below in the section on “Sales to an ESOP (Section 1042).”
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