Masonry Magazine May 1981 Page. 20
ESOP FINANCING
continued from page 18
How Does an ESOP Function?
Normally, for every $1.00 of profit, the successful corporation pays $.50 to the government and retains $.50 as additional capital. The $.50 of retained earnings would be available to redeem the stock of a selling shareholder, tax consequences notwithstanding.
With an ESOP, that same $1.00 of profit can be contributed to an ESOP trust before it is reduced by taxes. The trustee could be directed by the ESOP committee appointed by the company's board to buy $1.00 of newly issued stock from the corporation. As a result, the company would have $1.00 in cash and new capital instead of $.50 in retained earnings-an increase in incremental cash flow of 100%.
In practice, up to 15% of payroll could actually flow through the ESOP trust. With a payroll base of $500,000, for example, up to $75,000 in pre-tax earnings could be utilized in this way each year. But, the ESOP committee has yet another alternative.
As an alternative, the same $1.00 of pre-tax earnings, when contributed to the trust, can be used to purchase the existing company stock of an owner. Should the committee direct such a purchase from an owner, the corporation, of course, would not have the use of funds. However, in our example the corporation would only give up $.50 for every $1.00 of stock purchased from an owner. Again, the ESOP has increased by 100%, the cash available to liquefy the interest of an owner as compared to a corporate redemption.
An ESOP is also the only type of plan that may borrow funds to "leverage" the purchase of company stock. Using again a payroll base of $500,000 (recommended minimum for ESOP consideration), perhaps $400,000 could be borrowed by the ESOP trust and could be retired by yearly pre-tax contributions by the company. In this way both the principal and interest portion of the loan amortization would be made by dollars deductible by the corporation.
Who owns the stock held in trust? The trustee, who can be a company officer, is the legal owner of the stock, while the participating employees become the beneficial owners of stock through their vested interest in the ESOP trust.
Benefit to Employees
The employees have an opportunity to gain by their beneficial ownership of stock in the company. When they leave employment, the stock will be repurchased at its then fair market value as determined by the valuation parameters. During the time of employment, they make no contributions to the trust and they are not taxed on any allocations to their accounts. They are only taxed at distribution and then at a reduced rate. The stock repurchased from retiring employees is then available for new employees and maintains the ability of the company to attract key personnel.
Although no one can predict the future price of the company stock, the employee is now in a position, through his performance, to affect the overall value of the stock. As a risk/reward program, the profitability of the company, good or bad, will be reflected in the value of the company stock held in Trust for the employee.
ESOP Implementation
Although simple in concept, care must be taken when an ESOP is designed and implemented. A number of disciplines are involved and certain elements must be done on an arms-length basis. Each of the following must be taken into account:
1. Technical Design-Plan provisions that affect operation and participation.
2. Financial Design-How the cash generated is to be utilized to meet the needs of the owners and/or the corporation.
3. Legal The documentation must meet the specific provisions of the law and special regulations.
4. Valuation of Stock-This is a key element in each ESOP and, when properly done, avoids the conflicts that often arise within a shareholder group.
5. Employee Communications Program-Essential to the proper understanding of the ESOP by existing and potential key employees.
6. ESOP Administration-The most important function is that of taking overall responsibility of seeing that the ESOP accomplishes its intended purpose.
For more information about ESOPs, and a copy of an ESOP Practicality Survey, contact: Mr. Robert A. Manley, President, The Commonwealth Group, Inc., 601 California St., San Francisco, Calif. 94108, phone (415) 391-4687.
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