Should Your A&E Firm Hop on the ESOPs Trend?

Employee Stock Ownership Plans (ESOPs) will soon be available to more New York architecture and engineering (A&E) firms than ever before. Under new legislation that takes effect in less than two years, design professional corporations (DPCs) in the state can now be up to 100% ESOP-owned.

An ESOP is a type of employee benefit plan in which business owners sell ownership of the company to a trust which ultimately benefits their employees. For many companies, this effective succession plan can double as an exceptional employee retention tool and profitable exit strategy.

While the benefits of an ESOP are attractive, how do you know if it’s the right strategy for your A&E firm? According to Grassi’s A&E Practice Leader, Robert Brewer, and Tabitha Croscut, Shareholder at Devine Millimet, follow these steps to find out.

Determine your eligibility.

One ESOP requirement will rule out certain firms from the very beginning, and that’s the entity type. Because ESOPs are intended to be invested in stock of the sponsoring company, the business must be organized as a corporation, making partnerships, limited liability companies and other entity types ineligible for using an ESOP. However, those other types of entities could convert to a corporation in order to be ESOP viable. As far as employee eligibility, generally all employees are eligible to participate in a company’s ESOP, however, companies with fewer than 20 employees need to closely analyze whether an ESOP is feasible.

Another requirement is your business’s capacity to take on more debt. The stock of an ESOP-owned company is held in a trust for the benefit of the firm’s employees. The trust typically borrows money from a financial institution and/or delivers a promissory note to the selling owners in order to complete the ESOP’s purchase of company shares. Shares are then allocated within the ESOP to employees as the loans are paid.

Evaluate your leadership team.

Before embarking on an ESOP that will purchase a majority of the stock, identify the key members that would serve as the business’s future leadership team. Investigate their qualifications and appetite for that level of responsibility. A firm might need to work on leadership succession prior to implementing an ESOP.

Objectively consider the level of your leadership team’s business acumen as well. An ESOP is a complex business transaction like any other buy-sell arrangement. While a trustee will represent the employees’ interests and negotiate on their behalf, the trustee will not be involved in the day-to-day business operations, thus, the workforce needs to be positioned to continue the successful operation of the business.

 Predict the end result.

Even if your business is eligible and your management team is ready, there is still one major question to answer before deciding on an ESOP: Will it be successful and meet my financial objectives?

Depending on the size of your business, the complexity of the transaction and your long-term financial objectives, an ESOP may or may not meet your objectives in the long run. Obtaining a feasibility study is the most effective way to answer this question.

A feasibility study is conducted by legal and financial professionals to determine the practicality of a business plan or model. The first phase of the ESOP feasibility study will look at high-level factors such as the company’s historical and future profitability, size of company, debt capacity, workforce characteristics and other potential red flags.

If those factors are deemed favorable, the next step will be to run financial scenarios to analyze the overall profitability for the owners, the cash flow coverage for the company and the reasonableness of the benefit levels for the employees. This analysis will take into account the costs of establishing and running the ESOP, including advisor and trustee fees, valuation expenses, plan administration, and tax implications.

Given the massive fluctuations in revenue and expenses throughout the COVID-19 pandemic, it is especially important that the study uses normalized earnings when these numbers are run. Many companies may have more or less cash than usual in the bank, due to Paycheck Protection Program funds, employee retention credits, business shutdowns or other non-recurring capital spikes or revenue shortfalls.

The feasibility study will also uncover the percentage of ownership that is most beneficial to all involved parties to be transferred to the ESOP. An ESOP can hold anywhere from 1% to 100% of a firm’s stock.

This analysis is intended to give the firm and its management team the information they need to decide on whether or not the ESOP makes sense and will be sustainable. It can be conducted at any point in the business cycle, allowing for owners to choose the timing that produces the most favorable outcome.

Prepare early.

If you decide that an ESOP is right for you, take some time to prepare your company before proceeding. This is not a transaction you want to rush. If possible, take 12-18 months to get your culture ready, clean up debt, obtain a valuation, and line up your legal and financial professionals.

This up-front investment will position you to receive the best financial outcome and seamless exit that you and your business deserve.

Robert J. Brewer Robert J. Brewer is a Partner, past Executive Committee Member, and the Architecture & Engineering Practice Leader at Grassi. Rob began his career in 1987 and has extensive experience in tax planning, accounting, estate planning, succession planning, and mergers and acquisitions. Rob’s insight, wisdom and creativity allow him to provide expert business advice to a broad range of industries, including architecture & engineering, construction,... Read full bio