As discussed in our last article, Employee Stock Option Plans (or ESOPs) offer a number of advantages to both business owners and their employees. Nothing in the business world is a magic bullet - what works well for one company may not be the right solution for another. Here is a more in-depth look at some of the potential pros and cons of implementing an ESOP.

Four reasons to implement an ESOP

l Positive effect on employees: From the owner's perspective, granting employees the opportunity to hold equity can help to better align ownership interests with those of the workforce. Imagine you're an employee who has a chance to become a partial owner of your company.

Suddenly, you have an entirely new set of incentives. After all, you're buying shares at today's price, but will sell them back when you retire or leave.

Furthermore, the better the company performs, the better the stock performs - and the more money the employee realises at cash-out. That's an even bigger enticement for good employees to stay on board, and for all ESOP participants to find ways to increase share value. And when the fully vested employee does retire, there's going to be a natural market for those shares they're selling - the ESOP itself.

• Additional liquidity: ESOPs create a market for private shares of stock. By selling equity to the trust, business owners have the ability to either retain cash for operations or take cash out of their company without selling to outside parties. Business owners can thus gain liquidity without surrendering to the influence and demands of either financing sources or new external shareholders. When an owner leaves the business and needs to divest stock, an ESOP also provides a ready buyer for the outstanding shares and may actually be the first step to a management buyout. This can be particularly important for minority shareholders, who might otherwise be unable to induce their partners to buy the shares out at a 'fair' or established market price.

• Tax benefit: Local workers benefit from a tax code in which we are not exposed to the hefty income taxes levied in many countries around the world. However, both companies and individuals are liable for deductions tied to wages and salaries, including payroll tax and hospital levy. Dividends, the remuneration available through an ESOP, can be distributed deduction-free to employees, creating an economic benefit for both employers and employees.

Three reasons to be cautious

l Shared downside: If the company underperforms, even in the short-term, employees may become uncomfortable with the ESOP's lack of diversification. In a more extreme situation, if the company fails, employees risk losing the accumulated value of their shares.

• Added debt: Funding an ESOP requires adding leverage to the company's balance sheet. This can impact the company's ability to explore new opportunities, to borrow additional funds and even to finance operations in the near-term. Even if the company has significant cash reserves, it might be painful to tap those when it becomes necessary for the ESOP to buy back shares of vested employees upon retirement or departure.

• Transparency: An ESOP makes participating employees partial owners of the business. That might not sit well with long-time owners, who may chafe at the idea of employees having access to annual reports, annual meetings, and maybe even voting rights. This access to information can impact salary and other compensation negotiations and may also present a competitive liability where secrecy is key to competitive success in the marketplace.

The Bottom Line

A powerful tool and great incentive for employee performance and retention, the ESOP can be a boon to a business. With careful consideration and qualified oversight, it can provide distinct advantages.

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.