Employee stock option plans: Preserving a business and its legacy

The COVID-19 pandemic was an eye-opener for many privately owned engineering and construction companies. Although many businesses experienced negative impacts, the engineering and construction industry was deemed an essential service and stayed the course. Businesses in the industry, however, began to think about their succession planning strategy.  According to the 2021 FMI and Construction Financial Management Association’s Ownership Transfer and Management Succession Industry Survey, 50 per cent of engineering and construction companies reported they do not have an ownership transfer plan, while 27 per cent are uncertain to whom they will sell their business. The survey also found that internal ownership transfers continued to be the primary method by which businesses transitioned either to family members or employees.

The resilience of the construction and engineering industry during the pandemic triggered many business owners to consider an employee stock option or ownership plan (ESOP) as a means of preserving the business and its legacy which might be at risk with a sale to an unrelated party. Using an ESOP as a succession planning strategy can serve to protect the culture of a business—including its reputation, employee morale, and legacy.

Succession planning strategies   

Although an ESOP has numerous advantages as discussed below, there are other transition strategies that businesses in the construction industry can use. Some of these transition strategies include selling the business to a third party, selling the business to employees or management, selling or gifting the business to family members, or liquidating the business.

Employee stock ownership plans   

As an alternative, ESOPs can be used as an effective succession planning strategy. ESOPs are a type of business program that provides investment opportunities, compensation, and incentives for employees. Employees who have ownership benefits are more likely to be self-motivated and encouraged to actively participate and contribute to the growth of the business. Through ESOPs, employees purchase the business over a period of time and help reduce the financial strain of an outright equity purchase as the owners exit the business. A business can either provide the ESOP directly to employees or through an employee trust. One advantage of providing the ESOP through an employee trust is that employers can have the luxury of time to decide which employees should lead the business into the future.

Advantages of an ESOP

Some advantages of using an ESOP are that employees become vested in the success of the company and are more motivated to ensure the growth of the company when they become owners. In addition, the company will likely reduce its employee turnover which provides greater job security to employees and improves employee retention. Generally, there are no tax implications arising on the issuance of the employee stock option to the employee as the tax implications including any employment benefits arise when the stock options are exercised.  Since many of the companies in the construction industry are Canadian-controlled private corporations, the taxation of the employment benefit is deferred until the employee sells the shares.

What are the advantages to the owners of the business? They can sell a portion of their shares, allowing for dilution over a period of time. They can also stay active in the business and retain control. This can be achieved by permitting employees to take ownership of the business in small percentages by subscribing for the shares from the treasury, allowing the owner to defer the gain on the sale of his shares.  

Disadvantages of an ESOP

A formal valuation of the share at the time of grant, at the time of exercise, and on an annual basis may be required. This can pose both a costly and administrative burden on the company.  In addition, setting up an ESOP can have negative effects on cash flow due to the associated costs and the requirement to repurchase the stock of departing employees. Furthermore, the company is not permitted to take tax deductions for any employee stock option expenses. Including regular formal valuations, the tax and accounting compliance burden of setting up an ESOP is very high.

Takeaway

Business owners interested in exploring an ESOP as a means of succession planning should speak with their tax and accounting advisors to discuss their overall succession and estate plan.  A feasibility analysis of implementing an ESOP should be carried out, testing the assumptions that build an ESOP, calculating the expected benefits for employees, and determining whether an ESOP is a viable strategy for the owner.

While ESOPs are not ideal for all owners of construction and engineering firms, for some they can be an excellent succession planning strategy.