An Employee Stock Ownership Plan (ESOP) can be an effective way to create liquidity as well as serve as a means to transition your business to new ownership while providing an ownership benefit to employees.

The issue with other options such as selling to a strategic buyer or private equity firm, or even conducting an initial public offering, is that each option typically forces you to sell 100 percent of your stake in the business.

"One of the advantages with an ESOP is you can sell part of your company today, realize some liquidity and then stage subsequent sales of stock to the ESOP over time," says Elisabeth C. Schutz, senior vice president and market manager for the ESOP Group at Bridge Bank. "So you can ease out of ownership and management of the company and be grooming succession management to take over as you do that."

Smart Business spoke with Schutz about the advantages of an ESOP and the process you would follow to create one for your business.

What is an ESOP?

An ESOP is a qualified retirement plan. It's regulated by the IRS and the Department of Labor and came into being with the passage of the Employee  Retirement Income Security Act (ERISA) in the 1970s. The regulation is meant to ensure that the plan is used for the benefit of employees and that it's not just a sales tool where a business owner can sell at an inflated price.

It is a regulated transaction and remains so over time, so it's important that you find the right group of advisers to put it together. The laws have to be complied with in order to maintain status as an ESOP company.

Where do you begin the process of creating an ESOP?

First and foremost, you need to have an independent, outside valuation of the business conducted by someone not related to the company. You need to get a feel for whether the value meets what you are expecting to get for the company. That sounds pretty easy. But many business owners, when they learn of their friend down the street who sold their company for 10 times the company's earnings, think they're going to get the same kind of  multiple for their company.

Have the valuation performed by a firm that knows and understands ESOP valuations and start to look at how the transaction might be financed. It's essential to find a bank that is knowledgeable about how these plans work. There are significant accounting and regulatory issues that the lender needs to be aware of.

When should employees be brought into the process?

Typically, there are a number of steps. It's a process that on the short end can take three months, but some transactions can stretch on for a couple of years. It's not advisable to get employees involved early on. Typically that happens after the ESOP has been adopted and the financing is all arranged.

To be clear, the employees gain ownership over time. The ESOP is represented by a trustee who votes the shares of stock held in the trust. Employees don't have direct voting rights on most matters, although they do benefit from the appreciation of stock that is allocated to their accounts over time.

What are some other benefits to an ESOP?

There can be significant tax benefits to the selling shareholder. If the company is a C corporation and the owner sells to the ESOP, as long asthey sell at least 30 percent of their stock, they can take the proceeds, reinvest them in stocks and bonds of U.S. companies and not have to pay any capital gains tax on that sale. That's a very significant benefit to the selling shareholder.

That particular benefit does not accrue to S corporations. However, the way the law is written, the distribution of income from an S corporation to the ESOP is exempt from federal income tax.

So a 100 percent ESOP-owned S corporation pays no federal income tax, which is a very significant benefit to the company. Also, employee participants in ESOP companies benefit from annual contributions to the ESOP and appreciation of the value of the shares over time.

Before entering into an ESOP, you should gain advice from your own financial, tax and legal advisers and make decisions based on that advice and your own experience.