The popularity of Employee Stock Ownership Plans (“ESOPs”) is skyrocketing. Owners of many types of businesses are discovering the unique business, tax, and employee benefits of transferring ownership to their employees through an ESOP.
Despite the one-of-a-kind advantages of ESOPs, this trend has not yet penetrated the restaurant industry. We at GBQ foresee this changing, as we believe that ESOPs may be ideal ownership transition solutions for certain types of restaurant companies. What follows is a high-level overview since it is beyond the scope of this article to explain ESOPs in full detail. For additional information about ESOPs, click here.
How an ESOP Works
- An ESOP is a unique business succession and ownership transition tool that offers tremendous advantages to the selling shareholders, the company, and its management and employees (discussed in the following section).
- An ESOP is a qualified retirement plan, similar to a 401(k), which allows the employees of a company to become owners of the stock of their employer.
- As a benefit plan, ESOPs are governed by the U.S. Department of Labor.
- Several features make ESOPs unique as compared to other employee benefit plans, including: (a) only an ESOP is required by law to invest primarily in the securities of the sponsoring employer, and (b) an ESOP can borrow money.
- There are currently 6,000+ ESOP-owned companies in the U.S.
- Business owners may sell some or all of their stock to employees via the ESOP in exchange for a combination of cash (from the company and/or a bank) and seller financing (i.e., notes from the company).
- Selling shareholders receive fair market value over time plus a fair interest rate on seller financing; cash at closing would come from the bank or the company, with the sellers financing the remainder of the purchase price.
- Operational control and management of the company do not change after the sale to an ESOP. Selling shareholders typically remain in their current positions, and they are typically eligible to participate in the ESOP for as long as they remain an employee.
- ESOP shares are allocated to all eligible employees over a relatively long period of time, often 10 to 40 years. Shares are typically allocated based on compensation, although tenure may be considered in some allocation formulas.
- Employee participants receive an annual statement detailing their number of ESOP shares, value per share, total value in their account, and vesting percentage. Participants are able to sell their vested ESOP shares for fair market value when they leave the company. They receive cash if they are of retirement age, or they may roll the proceeds into an IRA if they are not.
What Types of Restaurants Should (and Should Not) Consider ESOPs
ESOPs may not be the right option for many restaurants; however, we believe there is a certain profile, or “sweet spot,” of restaurant enterprises where an ESOP may be an ideal fit. In our opinion, the key characteristics that make an ESOP more advantageous are:
- Value: The ideal size for a restaurant ESOP is approximately $5 million to $100 million in value (i.e., approximately $1 million to $20 million in EBITDA). Above $100 million, private equity and strategic buyers become more likely alternatives. Below the $5 million level, the cost of an ESOP may begin to outweigh the tax and business benefits. Additionally, there may be too few long-term employees to “make the math work” for an ESOP.
- Employees: To qualify for the most attractive tax benefits of an ESOP, the company must pass an anti-abuse test (i.e., IRC 409(p)), which ensures that ownership within the ESOP is broad and not overly concentrated with a few individuals. To pass this test comfortably, ideally, there would be approximately 20+ “core” employees who are expected to be longer-term team members (e.g., leadership, corporate, general managers, restaurant managers, etc.).
- Locations/Units: An ESOP can be attractive for restaurants with a single location or multiple locations as long as the size parameters above are met. For quick service, fast casual, pizza, or similar establishments, it may require 5 to 25+ locations to achieve the value targets discussed above. For larger or higher-volume restaurants (e.g., fine dining, craft breweries, popular “destination” restaurants, etc.), perhaps one to 10 locations are sufficient to meet the size criteria necessary for an ESOP. The Average Unit Volume (“AUV”) will play a role in the value and number of locations/units depending on your concept.
- Concentrated Ownership: The best ESOP candidates will likely have concentrated ownership. Oftentimes it may be a family-owned business. Perhaps it is owned by one or a few partners/investors. Ideally, there will be few (perhaps less than 10) owners, which will make it easier for the shareholder group to agree on an ESOP as an ownership transition option.
- Company-Owned vs. Franchisee vs. Franchisor vs. Independent Concept: The ideal candidate would operate company-owned units. Franchisees are not ideal candidates for an ESOP, as the franchisor often has ownership restrictions and/or rights of first refusal that make a sale to an ESOP difficult. Franchisors or Independent Concepts may be candidates for an ESOP, but they would need to be large enough to have the requisite number of long-term employees as mentioned above.
- Strong Leadership: To operate as an employee-owned company, there should be a strong and stable leadership team capable of operating the company. Restaurant companies where a select few individuals control all aspects of operations are not ideal ESOP candidates.
- Stable or Steady Growth: ESOPs are ideal for restaurants that demonstrate strong and stable performance, consistent profitability, and moderate to healthy growth. Underperforming or debt-laden companies are not good ESOP candidates. Also, restaurant chains with explosive growth plans (e.g., rapidly building a national brand) and intense needs for reinvestment are likely better candidates for private equity investors rather than an ESOP.
Based on these criteria, many restaurant enterprises are great ESOP candidates such as the favorite local/regional pizza chain that every city seems to have; the family-owned diner or casual restaurant that started in a single location but became so popular that it added locations throughout a city and perhaps in nearby cities or states; the college-town deli that has become a destination dining location for locals and anyone visiting the town; the iconic restaurant chain where there are autographed pictures on the wall of all the celebrities who have dined there; the restaurant that has become so popular that it sells t-shirts and other memorabilia at the checkout counter; the restaurant that when out-of-town visitors ask “where should I eat when I’m in town,” the answer is this local or regional favorite. If any of these descriptions resemble your restaurant chain (or one of your clients), then they may be an ideal candidate for an ESOP.
How ESOPs Can Benefit Restaurants, Their Owners, and Their Employees
According to the Employee Ownership Foundation’s annual survey, 95% of ESOP-owned companies indicated that creating the ESOP was a good business decision that helped the company. This overwhelmingly positive feedback is likely a result of the “triple win” that ESOPs make possible, as ESOPs can benefit: (a) selling shareholders, (b) the company itself, and (c) management/employees. There are many financial and non-financial benefits of an ESOP, and a few of the key advantages that restaurant companies and their owners can experience include the following:
Advantages to Selling Shareholders
- Succession Planning Solution: Every restaurant will eventually change ownership. With so many restauranteurs in their 50s and 60s, the “Silver Tsunami” is certainly affecting the restaurant industry. An ESOP is a unique vehicle that allows a restaurant owner to exchange their ownership for an attractive payment stream yet remain active in (and in charge of) company operations. ESOPs offer the gradual transition that many restauranteurs desire while allowing the selling shareholder(s) to monetize their investment and diversify their wealth as they transition toward retirement.
- Preserve Legacy: Many restauranteurs are immensely proud of their companies. They have spent a lifetime developing a special brand, culture, menu, etc., and there is often a strong desire to preserve this legacy. Further, there is a justified fear that a large acquirer or private equity investor will compromise the company’s culture, quality, reputation, or position in the local market (there are many unfortunate examples of this). With ESOP ownership, the restauranteur can ensure that there are absolutely no required changes to leadership, operations, etc. after the sale.
- Favorable Tax Treatment on Sale to an ESOP: Shareholders who sell ownership to an ESOP receive favorable tax treatment. An ESOP transaction is a sale of stock, which will qualify for capital gains tax treatment. Conversely, in asset sales (which are extremely common in conventional sales of businesses to other companies, individuals, or private equity buyers), certain assets (e.g., intangible assets, goodwill) may be eligible for capital gains treatment while others (e.g., receivables, inventory, fixed assets) may be subject to higher ordinary income tax rates. Furthermore, if certain criteria are met, selling shareholders may be eligible for an option only available in ESOP transactions called an IRC 1042 Rollover, whereby the capital gains on the sale can be deferred and possibly even eliminated.
Advantages to the Company/Restaurant
- Create an Income Tax-Free Entity: ESOPs offer tremendous tax benefits for companies. In what is clearly the greatest tax advantage of them all, ESOPs make it possible to create a business that is completely free of federal income tax and oftentimes free of state and local income tax. S-corporations don’t pay tax at the corporate level, so the income tax liability is passed through to the shareholders…but in the case of a 100% ESOP-owned S-corporation, the sole shareholder is a tax-exempt trust, so there is no need to make distributions of S-corporation income to cover the pass-through tax. Hence, the income tax-free company is a reality. No federal income tax. Period. With enhanced cash flow from the elimination of income tax, restaurants can more aggressively invest in equipment, new locations, personnel, or other growth initiatives. Barring a highly unlikely change in the tax law, 100% ESOP-owned restaurants will have a permanent advantage over their tax-paying competitors.
- Attracting and Retaining Employees: An engaged and committed workforce that has a vested interest in the success of a restaurant makes a difference. Numerous studies show that employee-owned companies outperform conventionally-owned companies. ESOP-owned companies routinely demonstrate (a) faster growth, (b) stronger profitability, (c) lower employee turnover, (d) greater financial security/retirement benefits for employees, and (e) a stronger image in the market among potential and existing customers.
Advantages to Employees
- Valuable Retirement Benefit: ESOPs provide the opportunity for employees to own a piece of the company they work for. Identical to a 401(k) plan, shares accumulate in an ESOP account tax-free, and tax is ultimately paid when the account is cashed out (typically at retirement). Traditionally, restaurant employees have not enjoyed meaningful retirement benefits. An ESOP makes it possible for restaurant employees to accumulate wealth they otherwise would not have access to.
- Especially Rewarding to Key Management: One advantage of ESOPs that is fairly unique to the restaurant industry is that due to the composition of the workforce in most restaurant companies, the vast majority of the ESOP’s economic benefits are likely to be allocated to the key management group (which is often the most important group that selling shareholders wish to reward). The eligibility, allocation, and vesting rules of ESOPs favor employees with longer tenure and higher compensation. Since turnover among staff-level employees is often high, and often many of those are part-time employees, it is likely that many of those employees will not qualify for share allocations in the ESOP and/or will not remain with the company long enough for those shares to vest). As such, most shares are likely to be allocated to corporate, leadership, and other management-level employees with longer tenures and higher compensation levels.
Summary and Next Steps
Due to the unique financial and non-financial benefits of ESOPs, we believe that ESOPs are ideal ownership transition alternatives for certain types of restaurant companies. If you wish to learn more about ESOPs, GBQ offers a wealth of information, including our website, seminars/webinars, and articles. Better yet, feel free to contact a member of GBQ’s ESOP Advisory team for a complimentary discussion to assess whether an ESOP may be an option for your restaurant company.
About GBQ’s ESOP Advisory Practice
GBQ is a nationally-recognized authority on ESOPs and a proud advocate of employee ownership through ESOPs. We work with 100+ ESOP companies annually, and our ESOP clients can be found across the country. GBQ specializes in ESOP feasibility studies, formations/implementations, transactions, and valuations. We have successfully guided many companies through the initial evaluation, design, and implementation of an ESOP. We are frequent speakers and authors for leading ESOP organizations including the ESOP Association, the National Center for Employee Ownership, and the Ohio Employee Ownership Center.
Article written by:
Director of GBQ Capital Advisors