ESOPs for Professional Service Firms

For over 150 years, the dominant model of ownership for professional service firms had been the partnership. It had a good run, but its time has passed.

For accountants, lawyers, architects, engineers, investment bankers, and countless niche professionals, even valuation professionals, the partnership no longer serves their needs. Leaders of these firms are looking for new ownership models that meet the changing priorities of new generations of professionals and support investments in technology, all while securing the buyout of retiring partners.

The practice of paying all profits out to a large group of owners who also all have a seat at the leadership table no longer works in today’s economy. Firms need to use profits to invest in technology and to fund a generational wave of partner retirements. The leadership by consensus that characterizes traditional partnerships is too slow for today’s dynamic environment.

Firm leaders are seeking new models that allow firms to build equity and separate leadership from ownership. We explored this trend last year in the paper: Beyond the Partnership – New Models of Professional Service Firm Ownership. In this paper, we will explore how firms are using an ESOP to help meet these challenges.

Overview of ESOPs

ESOPs have become a popular way to provide the benefits of ownership to rank-and-file employees while also providing a tax-advantaged exit option for existing firm owners. ESOPs are broad-based retirement plans that generally allocate employer stock to all employees (with certain exceptions) in the form of a retirement contribution. With an ESOP, employees earn stock in their employer over time, without putting in any of their own money, often building up a valuable nest egg for retirement.

An ESOP is a qualified retirement plan under ERISA, so it operates under strict regulations. The plan purchases stock from existing owners and allocates that stock over time to a trust account for the benefit of employees. Each employee earns stock in their account annually in proportion to their wages, similar to a 401(k) or profit-sharing contribution. When the employee retires or leaves, the stock is cashed out, and the former employee can roll the proceeds into another qualified retirement account or take the cash (subject to normal retirement account taxes and early-withdrawal penalties).

For sellers, an ESOP can provide much more flexibility and tax advantages over a sale to an outside buyer. The ESOP can buy some or all of the outstanding stock, and the sale transaction can be structured to optimize tax and other factors for the sellers. Employees get the benefit of indirect ownership without putting in any of their own money, and the company gets tax savings that are not available to non-ESOP companies. If the ESOP owns 100% of the stock, the company no longer pays federal income tax (or state income tax in most states).

ESOPs for Professional Service Firms

ESOPs have long been popular ownership structures among architecture and engineering firms. More accounting firms have been implementing ESOPs in recent years, with BDO being a high-profile recent example. Likewise, firms in niche professions have found ESOPs attractive as a perpetual ownership model that provides an exit to existing owners while maintaining the independence of the firm indefinitely.

Professional service firms will often implement an ESOP with three main goals:

1. Buy out a wave of retiring partners
2. Concentrate leadership
3. Secure long-term firm independence

Before committing to an ESOP, there are two fundamental decisions that firm leaders will need to make:

1. How will we compensate producers?
2. Who gets a seat at the leadership table?

In the shift from a partnership in which producers are owners who share in firm profits, leaders have to decide how producers will be compensated. For the ESOP to work, compensation structures need to allow the firm to retain meaningful profits to build equity in the enterprise while also providing competitive incentives. With an ESOP, compensation can include a mix of short-term incentives including commissions and performance bonuses, and long-term incentives such as equity incentive plans for specific roles. The ESOP itself provides long-term incentives for all employees.

The shift to an ESOP is often the opportunity to streamline a bloated leadership structure. Without “partners”, an ESOP-owned firm can concentrate decision-making within a C-suite leadership team. This can often be accomplished in conjunction with buying out a generational wave of retiring partners. The tax benefits of the ESOP, combined with compensation changes help provide funding to finance such buyouts.

While there are technical considerations unique to some professions, such as state licensing requirements for CPA firms, these can be addressed in the ESOP design process.

Ultimately, today’s generation of professional service firm leaders are finding that ESOPs can provide the framework to adapt to the changing needs of professional staff and adapt to new competitive environments, while securing long-term independence for their firms.

Read on to learn more about the factors that can make a firm a good fit for an ESOP, and contact Adamy to discuss how an ESOP can fit your goals.