Capital formation is a continuing challenge in the present economic and business environment. If one defines capital as equity in nature, then the world of investors is by and large closed to the private, closely held business. If, on the other hand, one defines capital as debt in nature, then business owners find great difficulty in dealing with commercial banks or mezzanine financing sources. Some business owners prefer to build capital the "old-fashioned way" – through profits. This last method is the best of all worlds, but sometimes profits cannot be earned quickly enough to satisfy the needs and accomplish the goals of the enterprise.
Suppose ABC needed a $500,000 operating line of credit, but the bank declined the request because of a lack of capital or sufficient net worth. Suppose also that ABC has been making annual cash contributions to an employee benefit plan in the amount of $100,000. In order to build capital, the company starts an ESOP and temporarily suspends contributions to the other qualified plan, instead contributing the entire $100,000 to the newly created ESOP. The ESOP uses the money to purchase treasury shares or previously unissued shares from the company. In this way, ABC can build capital while continuing to make contributions to an employee benefit plan.
Using an ESOP in this way does not increase out-of-pocket cash costs. The company actually is increasing its capital base by making contributions to an ESOP instead of a profit-sharing or 401 (k) plan. Of course, companies must pay careful attention to the issue of dilution. These techniques are to be used sparingly and only after a great deal of thought and consideration as to the consequences of all actions taken.
As you can see, employee stock ownership plans are a powerful tool in todayÕs world of corporate finance. Their uses are varied, and their advantages can be wondrous. Like any other sophisticated financial tool, however, ESOPs must be planned and structured properly. Whether for building capital, reducing taxes, growing through acquisitions, planning management succession and ownership transfer, or reducing the cost burden of employee benefit packages, employee stock ownerships deserve careful consideration by companies as a tool for future success and staying power in an uncertain economy.
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