Essential Factors in Deciding

Whether to Establish an ESOP

Not all companies are fit for an ESOP. The decision to create an ESOP is a significant one, and it requires careful evaluation beyond enthusiasm or the appeal of tax deferral. Two critical considerations stand out when evaluating whether to move forward: (1) independence of the valuation expert, and (2) whether the company is operationally, financially, and structurally suited for ESOP ownership. The author discusses the consequences of sponsoring an ESOP.

For many closely held business owners, the question of succession planning often leads to consideration of an Employee Stock Ownership Plan (ESOP). ESOPs offer a unique structure that allows a business owner to sell all or part of the business to its employees, providing both an exit strategy and a legacy of employee ownership. On the surface, ESOPs can appear to be the ideal solution; offering tax advantages, employee motivation, and a ready market for the owner’s shares. But not all companies are fit for an ESOP.

The decision to create an ESOP is a significant one, and it requires careful evaluation beyond enthusiasm or the appeal of tax deferral. The Department of Labor (DOL) imposes strict fiduciary standards and the ongoing operational and financial burdens of maintaining an ESOP can become unsustainable for many small and medium sized enterprise companies. Two critical considerations stand out when evaluating whether to move forward: (1) independence of the valuation expert, and (2) whether the company is operationally, financially, and structurally suited for ESOP ownership.

1. Independence of the Valuation Expert: Lessons from GreatBanc and Beyond

At the heart of any ESOP transaction is a fair market value determination. Under ERISA, the trustee of the ESOP must ensure that the plan does not pay more than “adequate consideration” for the shares of the company. This valuation must be rendered by a truly independent appraiser; one free from any potential conflicts of interest or prior affiliations that may bias or appear to bias fair market value.

Over the past decade, enforcement actions and legal proceedings by the DOL have clarified this requirement. A notable case—Perez v. GreatBanc Trust Co.—underscored this point.^[1] The DOL alleged that the trustee for the ESOP in question breached its fiduciary duties by relying on a valuation expert who had a prior relationship with the company. Though the parties eventually reached a settlement, the case set a precedent: if a valuation expert has previously performed valuations or other work for the company (even for non-ESOP purposes), the DOL may determine they are not independent.

This interpretation has practical and strategic implications. Many small and mid-sized businesses have long-standing relationships with valuation experts who have performed fairness opinions, buy-sell valuations, shareholder interest appraisals, or estate planning-related work. When it comes time to consider an ESOP, it can be tempting, even sensible, to retain a familiar professional who knows the operations well. However, the DOL’s view is that even a well-regarded, credentialed expert is not independent if they have previously valued the company’s stock for another purpose.^[2]

Owners and boards must therefore be prepared to engage a new, truly independent valuation expert who has no prior financial ties to the business. This shift can be disappointing for owners who have built trusted advisory relationships, but it is a non-negotiable aspect of DOL compliance. Failure to adhere to this standard can result in fiduciary breach claims, costly litigation, and potential plan disqualification.

Additionally, even the ESOP trustee must be free from conflicts. The trustee must make the final decision regarding the purchase price the ESOP will pay for the company stock, relying heavily on the independent valuation. If the trustee is hand-picked by the owner and lacks independence, this too could raise red flags.^[3] 

2. Is Your Company a Viable Candidate for an ESOP? Key Structural and Financial Concerns

While many owners are drawn to the narrative of employee ownership, an ESOP is a costly and complex structure. It is important to understand that ESOPs are subject to ongoing fiduciary duties, regulatory oversight, and complex administrative tasks. Companies that are too small, under-resourced, or unstable, may not be able to sustain the plan long-term.

Several key factors should be evaluated:

a. Costs are Ongoing and Significant

One of the most common misconceptions among owners is that ESOPs are a “one-and-done” transaction with upfront legal and valuation fees, this is not the case. ESOPs come with recurring, annual costs; and for smaller, or unstable businesses, these can be prohibitive.

• Trustee fees: A qualified, independent trustee must oversee the plan and protect the interests of the employee-owners. Trustees charge annual fees for this oversight and costs more than not if litigation or investigations arise.
• Valuation fees: A new valuation must be performed every year to determine the value of the shares held by the ESOP. This valuation is critical for participant account allocations and repurchase obligations.
• Third-party administrator (TPA) fees: ESOPs require technical recordkeeping, compliance testing, and IRS filings (e.g., Form 5500 with Schedule R). TPAs charge recurring annual fees to manage this process.

Combined, these costs can range from ~$50,000 to well over $150,000 annually, depending on the size and complexity of the plan. For a company generating $500,000 to $1 million in EBITDA, this may be a disproportionate burden; diverting funds that would otherwise support growth or dividends.^[4]

b. Workforce Composition—Do You Have W-2 Employees?

A company with a transient or outsourced workforce may not be a good candidate for an ESOP. To qualify, employees must generally be W-2 workers, not 1099 independent contractors. The IRS and DOL will scrutinize the company’s employee classification practices to ensure that benefits are extended to eligible participants under the law.^[5]

If a business operates with a small team of permanent employees and a large group of freelance or contract workers, it may be difficult to maintain the integrity and inclusivity required by an ESOP. Additionally, employee turnover affects vesting, morale, and plan longevity.

c. Is There Excessive Personal Goodwill?

If the value of the company is tied closely to the reputation, relationships, or skillset of one person—typically the owner—the ESOP may have little real transferable value. This is particularly true in service businesses such as consulting, professional practices, or personal-brand-driven enterprises.

While personal goodwill can be a valuable asset for tax purposes, it poses a problem in ESOPs. The ESOP is purchasing the company, not the individual. If the owner plans to exit and the business depends entirely on that person, the sustainability of the ESOP may be called into question by the trustee or valuation expert.^[6]

d. Is Profitability Stable or Growing?

Finally, the financial health and trajectory of the business is essential. ESOPs rely on cash flow to cover administrative costs, service internal debt, and meet repurchase obligations; the obligation to buy back shares from departing or retiring employees.

If a company’s earnings are volatile, on a downward trend, or artificially inflated by short-term events, the ESOP may quickly become unsustainable. This creates not only a business risk, but also a fiduciary risk to the trustee and plan participants.

A company with flat or declining revenues may also find it more difficult to obtain bank financing for a leveraged ESOP transaction, further compounding the problem.

Conclusion: The Right Structure at the Right Time

Creating an ESOP can be transformative for employees, the selling owner, and the legacy of the business. But it is not a turnkey solution or a decision to be taken lightly. As exciting as the benefits are, the reality is that an ESOP must be built on the right foundation: financial stability, a scalable workforce, a transferable business model, and compliance with regulatory safeguards like an independent valuation.

If your company meets those standards, an ESOP may offer a tax-efficient, values-aligned succession plan. But if not, forcing the fit may lead to disappointment, legal scrutiny, or financial strain.

As always, owners considering an ESOP should begin with a feasibility study conducted by independent professionals who understand both the technical and cultural elements of the transition. And if your current valuation professional has already worked with you in another capacity, do not assume they can cross over because in the eyes of the DOL, familiarity can be a liability.

^[1] https://www.dol.gov/newsroom/releases/ebsa/ebsa20140602

^[2] https://www.dol.gov/agencies/ebsa/about-ebsa/our-activities/enforcement

^[3] https://www.dol.gov/general/topic/retirement/fiduciaryresp

^[4] https://www.nceo.org/what-is-employee-ownership/esop-employee-stock-ownership-plan

^[5] https://www.irs.gov/retirement-plans/employee-stock-ownership-plans-esops

^[6] https://www.nceo.org/resource-toolkits/esop-pre-feasibility-toolkit

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Trisch Garthoeffner, ABV, CVA, MAFF, EA, MAcc, has 20+ years of experience in providing business valuation, financial forensic, and merger and acquisition consulting services. In 2020, she was elected to the NACVA Standards Board; in 2021, voted vice-chair; in 2022, voted chair; and is a current Executive Advisory Board advisor for the NACVA Standards Board. She is a past Florida state chapter president for NACVA, a current member of the NACVA exam task force, a board member and quarterly author for the QuickRead valuation periodical, a past treasurer of the Florida Academy of Collaborative Professionals, and a past vice-president of the Southwest Florida Chapter of Collaborative Professionals and current member. In 2024, Ms. Garthoeffner was nominated as a member of Business Valuation Resources (BVR) Leadership Council. On March 06, 2025, she will be in Washington DC with other NACVA representatives[1] to testify regarding NACVA’s collective input regarding the Treasury Department’s proposed rule – Regulations Governing Practice Before the Internal Revenue Service. In her spare time, she enjoys spending time with her daughter, exercising, antiquing, and fostering animals.

Ms. Garthoeffner can be contacted at (239) 919-3092 or by e-mail to trisch@anchorbvfs.com.

[1] T.J. Liles-Tims and Dalton Hopper.