Home November 2019 The ESOP Option

The ESOP Option

Your company-invested successors could be the people you work with every day

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When it comes time to hand over the company reins, but you don’t have an heir or your heirs are not interested, how do you keep the legacy going? Glen Demke, enterprise tax partner from KPMG in Canada’s Edmonton office has some advice.

“An Employee Stock Option Plan (ESOP) is an equity-based compensation plan intended to align an employee group or management’s interests with those of the shareholders, by providing individuals with an interest in the performance of the corporation’s stock/business.  These strategies have a history of being used not only to include the employees in the future plans of the business, but also to attract and retain top level talent,” explains Demke.

He notes that ESOP is best suited for a small to medium sized business and that there is a growing trend where ESOP is used as a form of transition or succession planning.

“We see this as a driving force where the business owner has no family members that have expressed an interest in the future of the business and there is a limited market of potential buyers outside the employee/management group.”

He continues, “ESOPs are customizable, which is why they are such a powerful structure when dealing with transition and succession planning.  Strictly speaking from a tax perspective, the company does not have to put up any cash when the employee exercises the stock options. This helps the company to retain and preserve its existing cash flow.

“The employees can defer the tax incurred when exercising those stock options until the disposition date, and still receive a 50 per cent deduction (in most circumstances). It helps to think of this option as how capital gains are taxed. Capital gains realized by the employee upon disposition of the shares may be eligible for the capital gains exemption if the shares qualify as small business corporation shares at the time of sale.”

Demke also notes, “I would be remiss if we talked about the advantages without bringing caution to some of the disadvantages. Although no cash is required by the company when they provide an ESOP structure, the company also does not get a tax break. Additionally, the company may have to list the procedure as a compensation expense (benefit) in their accounting. Don’t forget that issuing new shares, even to employees, dilutes the shareholdings of the company and this could cause issues with control of the corporation.

He continues, “The most important thing every business owner should have when using the ESOP structure is a plan in place to transition without destabilization. And when the plan is implemented, everyone involved must remember that a tax burden falls on the employees. Further the business owner has to recognize that the employee shareholders now have legal rights as owners that should be considered with legal counsel prior to implementing the stock option plan.”

There is a lot to learn before implementing an ESOP, but firms like KPMG can help. Another valuable source of knowledge is the ESOP Association of Canada, which promotes ESOPs and hosts educational events, shares research, and brings together the community of employee-owned companies.

“We currently have just over 200 members and another 500 contacts in our database,” says Dean Ell, chair of the association. “Over the past five years we have hosted a very successful annual ESOP Conference that starts with a meet and greet before diving into one and a half days of ESOP success stories, ask-the-expert keynote sessions, tax and valuation sessions, succession planning, networking, and so much more.”

Ell mentions big plans for the Association as it continues to grow.

“In the coming years and as our conference grows in attendance, it would be wonderful to have the resources within the Association to focus efforts towards lobbying the governments of our great country to offer tax incentives for ESOP companies.”

He firmly believes in the many advantages of ESOP.

“ESOP companies have highly engaged employees who take on more responsibility. It’s a great recruiting tool, turnover and absenteeism drop, and you will see increases in productivity, which all benefit culture and profitability.”

Ell cautions not to be swayed in your opinion if your only knowledge of ESOPs comes from America, as the system across the border is very different from the way they are handled in Canada.

“ESOPs in the USA are highly regulated; in Canada we can quickly and easily change and adapt our ESOPs if the need arises. You can create a set-it-and-forget- it ESOP or have an evolving ESOP that changes as your business changes,” he advises.

Demke is also keen on ESOP’s Canadian advantages.

“One of the great benefits to transitioning to an ESOP structure is the flexible timeline it offers as well as the flexible structure itself,” he says. “Generally, when we work with our clients on transition planning, we recommend starting the process at least two years in advance, even better if it can be five.  That being said, the ESOP structure typically allows the business owner to transition the business on their own timeline and maintain control of the company until such time as they are ready to walk away.”

“The timeline for a full transition is different in every situation with major factors being the number of key employees that are participating in the ESOP structure and the value of the business itself.  It is our experience that the employees are often not familiar with the process and education is likely required to allow them to fully understand the benefits of what is being offered to them.  If the employees do not grasp what is being offered to them, then it is likely that the benefit of engaging the employees in the future growth of the business will be minimized.”

Joanna Phillips is the vice president of ESOP Builders, a company that has been designing and implementing ESOPs in Canada for over 20 years for a variety of clients in many different industries.

“A typical question for business owns may be, why have an ESOP; why sell to employees?” says Philips. “There are varying levels of success found with different exits. A sale to family (second generation) is only 30 per cent successful, a sale to an external third party is only 50 per cent successful. However, a sale to the employees has an 80 per cent success rate! Why? We believe it is because your employees are the most knowledgeable about the business and its operations, they are already mentally invested and committed to their role, and providing ownership means they become even further invested in the success of their company.”

She concludes, “Typically there are three main reasons that bring owners to the decision to implement an ESOP: attract the best talent, retain their brightest and most committed people, and exit on their own terms while keeping the company culture intact.”

ESOPs are a wonderful succession tool that are slowly but surely gaining ground in Canada. Learn more by searching employee stock option plans on kpmg.ca. You can connect with ESOP builders at esopbuilders.com. Consider the ESOP Association of Canada’s 2020 conference in Regina on June 1-3 (www.esopconference.ca) where new and seasoned ESOP companies will be in attendance to enjoy time connecting, sharing, learning, networking and growing their companies.

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