Employee Stock Ownership Plans (ESOP’s) can be effective exit strategies for business owners, especially those who preplan in advance of their exit date. Often times business owners initially don’t like the concept when it is first presented. However, after reviewing their situation with an ESOP attorney and later running some tax numbers with their certified public accountants (CPA’s), some business owners change their mind and decide an ESOP is right for them.
Do ESOP companies perform well?
Some employee owned companies / ESOP companies do very well. Business owners often tend to be more ambitious than some employees. Much of this may be personality and drive, but business owners also typically realize that the better their company performs, the better they do. Simplified, an ESOP is a plan in which an employee retirement plan in the form of an employee stock ownership trust (ESOT) purchases stock from the owner of the company. As owners, employees may very likely have more positive attitudes toward work, more ambition, and more of a sense of ownership. They might not be so inclined to take that extended lunch, and they might correct any fellow employees that take an extended lunch. Furthermore, they may take quality, workmanship, and customer satisfaction much more seriously. The employee invests nothing and has a potential for large gains over time. It may be a win-win for employees and a great way to take care of loyal long term employees. Additionally, stock warrants or stock options may be able to be offered to key employees if desired.
How does it all work?
In simple form, basically the ESOP creates an avenue for the ESOT to purchase the business owner’s stock. The problem becomes that the ESOT is similar to a new born baby fresh out of the womb. The ESOT has not credit, no cash, and no assets to leverage against to borrow. Some acquisition capital can be gained from borrowing against assets that the company has equity in. This can make asset rich companies, especially those with real estate / real property, good candidates for faster payment to the stock selling shareholders. The remaining buyout capitalization can take place over time through company profits to fund the buyout.
What is in it for the owner?
At first glance, the owner might think it is unwise to give profits to the ESOT instead of taking them directly. This is where serious conversations need to take place with an ESOP lawyer / ESOP attorney and a qualified CPA familiar with ESOP’s. Much of profitability may be taxed as regular income at a high tax rate. Working with a CPA, the owner may find out that he or she can do much better with long term capital gains tax through the stock sale vs. regular income. But it may get much better than that with proper planning through an ESOP attorney and CPA. The money the owner receives for the stock sale may be able to avoid capital gains tax by investing in qualified replacement property (QRP). It is often referred to not as ‘tax free’, but rather ‘tax deferred till death.’ Working with your CPA, you may then find that beneficiaries under your will may receive a step up in tax basis, and beneficiaries not owe tax on the money either. Okay, the owner may want to spend some of the money now and not pass it all to beneficiaries of his or her estate. How can this work? With a good ESOP attorney and CPA, things can very likely be setup to borrow against the QRP instead of actually taking out the principal capital. There may be a small percentage of spread, but with proper planning this may very likely be much less than taxes owed. Another potential tax advantage not yet discussed, there may also be significant tax advantages to the company being owned by a tax deferred retirement plan, and thus leave more money after tax from the profits for the stock purchase.
What about company control?
At least at the time of the sale, the selling owner can maintain control of the company. Some owners also choose to do a partial ESOP or staged ESOP sale instead of selling 100% of their shares up front. For instance, if an owner sells 49% of his or her shares to the ESOT, the owner can still maintain day to day control of the company as well as keep a majority vote of the shareholder’s stock. This can be maintained for a period of time while the ESOT is paying for his or her sold shares. During this time the selling shareholder can also be training successor management even if succession planning and training was not carried out previously. Later on, the selling shareholder may decide to sell the rest of his or her stock to the ESOT. The ESOT may be in a better capital position, and if the company performs well under the ESOP as many do, the remainder of the stock may have a higher value than the original selling price per share of stock.
Is an ESOP a good option?
An owner may at first glance say that he or she would rather sell their company to a third party, collect their money, be done, and retire or move on. However, after careful review with an ESOP attorney and CPA looking at the potential for return on investment (ROI), the same business owner may change his or her mind. This is especially true when examining other options. For example, a cash buyer for the business may very likely only be willing to pay a much lower price. Alternatively, with seller financing to a third party buyer, there is risk of how well the new party will perform, especially with a change of control of the company. It should also be noted that there are several regulations controlling whether or not a company can do an ESOP. Since all companies are somewhat unique, each company should start with an ESOP feasibility study through and ESOP attorney working with a CPA. Together they can address feasibility and look at if the ESOP is likely to be lucrative.
What is the value of the stock sold through the ESOP to the ESOT?
The stock sold by an owner through an ESOP to an ESOT should be valued by a professional valuator. This means that the selling shareholder should be receiving fair market value for his or her shares, and receiving it with very favorable tax incentives. Comparing this to a cash buyer potentially dramatically reduced price per share with higher taxes, or perhaps an asset sale with potentially some of the sale being taxed as regular income, often times a business owner calculates distinct advantages to an ESOP.
Are there extra paperwork and expenses?
The short answer is yes. There are setup expenses, valuation expenses, and annual maintenance reports and expenses. On the other hand, a third party sale typically includes a negotiated sale, a purchase agreement, closing, and legal expenses. With a third party sale there can also be brokerage expenses, seller financing, third party financing issues, and the infamous buyer’s remorse.
An ESOP may or may not be the proper exit strategy for a seller, but in most cases it certainly warrants investigation.
Attorney Kirk E. Mentch, Esquire
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