A major challenge for local business owners is the hiring, attraction and retention of quality employees. One solution that could be appropriate for the larger private companies, but which is not yet prevalent, is the establishment of ESOPs. For our purposes, the term ESOP doesn't refer to an ancient Greek storyteller who tells fables about talking animals - an ESOP is an Employee Stock Ownership Programme.

What is an ESOP?

ESOPs are remuneration plans that businesses can offer employees as part of their compensation. In addition to allowing employees to benefit directly in the upside results of the company, ESOPS have the added benefit of increasing liquidity for business owners. So, what does that mean in plain language? Simply put: ESOPS allow you to sell part of your business to employees and buy it back later. In many ways, partnership structures in legal, accounting and other professional service firms share ESOP attributes.

In order to establish an ESOP, the company would set up a trust into which it either contributes equity (shares) or cash to buy existing shares. Allotments of shares are allocated to individual employee accounts, and allotment size can be determined by a combination of criteria including tenure, level of pay, level of responsibility etc.

Graduated vesting of shares is a useful practice for further encouraging employing retention. With graduated vesting employees benefit over time from an increasing proportion of their allocation, based on the amount of time they have participated in the programme.

While employed by the company, employees receive the dividends commensurate to their level of stock. Depending on the rights assigned to the shares, employees may also have some level of "ownership control" over the direction of the company. Upon leaving, the company must buy back the allocation from employees (this is sometimes paid in instalments). The value of this stock can either be calculated using a pre-determined formula or by using the assistance of a valuation professional.

Is an ESOP appropriate for my business?

ESOPs are powerful vehicles to assist owners with transferring part or all of their businesses. Unfortunately, they can also be complex to implement and administer. Points to consider include:

l UP-FRONT COSTS: Like any benefit plan, it takes money to set up an ESOP, and often it takes more money to establish than other benefit packages require.

• ONGOING EXPENSES: Once it is established, an ESOP isn't much good unless the company can afford to make contributions to it. Are you willing to forego some discretionary spending in order to acquire the shares the ESOP needs?

• CONTRIBUTIONS vs. PAYROLL: There are practical limits to how much can be spent on an ESOP. Do you have a retiring owner who wants to sell millions of dollars' worth of shares to the plan? Make sure the company's payroll is big enough that the necessary expenditures can be made within the ESOP's rules.

• IS EVERYONE ON BOARD? There isn't much point in having an ESOP if employees aren't interested in investing in the company; and if partners or management aren't ready to see employees take an ownership stake, that could lead to morale problems. Make sure there's uniform support for the plan before establishing it.

How do I go about setting up an ESOP?

Having determined that an ESOP is both appropriate and feasible for your business, you will have to take specific action.

• FIND OUT WHAT YOUR COMPANY IS WORTH: A valuation is an essential tool for any business considering an ESOP. It gives a realistic picture of share value, which is what drives an ESOP. If the company value is too low, who would sell to the plan? If it's too high, could the company afford a buy-back?

• DETERMINE A FUNDING STRATEGY: ESOPs are flexible in that they can be funded through a number of methods, including loans, direct contributions from company accounts, and even transferring money from certain other benefit plans. Each has advantages and disadvantages and should be studied thoroughly.

• GET PROFESSIONAL HELP DURING SET-UP: In addition to a valuation professional, you should retain an attorney who specialises in ESOPs to assist with drafting the language of your agreement. As with any financial instrument, an experienced lawyer is the best way to make sure your company doesn't accidentally miss any of its legal obligations. A trustee must also be named to help provide direction. The most immediate task of the trustee is to encourage participation by as many qualified employees as possible, because an ESOP only works if eligible participants actually participate.

Read part two on ESOPs in this column on April 23

This article is part of a series reflecting on some of the 'best practice' issues and considerations relevant to owners of privately held companies. Asgill Post Ltd. provides assistance with Business Valuation, Financial Strategy and the Purchase and Sale of Companies. For comments or queries, contact Kumi Bradshaw MBA, CBA, BVAL via email at kumi@asgillpost.com or phone at 295-3301 Patterson Partners Ltd. provides Bermuda/US cross-border tax, estate and investment planning services. For more information, visit www.patterson-partners.com or contact Jennifer A. Patterson, CFP®(US), CIMA®, TEP via email at info@patterson-partners.com or phone 296-3528.