Article written by:
Eric Dollin, ASA
Senior Manager, Valuation & Financial Opinion Services
Planning for ownership transition can be one of the most important decisions that an owner will make during the life cycle of their business. In many situations, and for many companies, an Employee Stock Ownership Plan (ESOP) may be an attractive alternative to a traditional sale of the business to a third party. However, there are several factors to consider as a seller contemplating a sale to an ESOP, including the following:
What is an ESOP?
An ESOP is a qualified retirement plan governed by ERISA and the Department of Labor. Following a sale to an ESOP, shares of the company are released on an annual basis to employees (generally based on tenure or salary), providing a retirement benefit that allows employees to benefit from the performance they drive in the companies for which they work.
What are the Sellers’ Goals?
There are a number of different routes a business owner can pursue when looking to transition ownership of their business, including sales to financial buyers (e.g., private equity), competitors, suppliers, or a sale to an ESOP. Certain “strategic” buyers (e.g., competitors) are often motivated by potential synergies and operating efficiencies created by an acquisition, and as such, are often willing to pay a premium in a transaction. In contrast, an ESOP is not able to pay in excess of Fair Market Value (essentially the value to a financial buyer). While the initial potential higher proceeds available from a strategic buyer may be attractive to a potential seller, the higher proceeds may come at the cost of ceding control of the strategic direction of the business, changes to company culture, and potential changes to staffing, all of which can be avoided in a sale to an ESOP.
Potential Tax Savings from ESOP
Although a seller may be able to achieve higher initial proceeds from a sale to a strategic buyer, an ESOP brings several unique tax advantages to the table that would otherwise be unavailable to a non-ESOP owned company. Specifically, sellers of C-corporations have the ability to defer capital gains on the sale to an ESOP and have the potential to realize a step-up in basis (assuming certain requirements are met). Additionally, ESOP-owned S-corporations do not pay federal income tax on the ESOP’s share of earnings (as S-corporation income is passed through to shareholders, and the ESOP, as a qualified retirement plan, is tax-exempt). These S-corporation tax savings contribute to growth in share value over time (through cash accumulation or reinvestment in the business), which the selling shareholder may benefit from if they remain with the business following the sale.
A large number of ESOPs are sold in leveraged transactions. For larger transactions such as the sale of 100% of the company’s shares to the ESOP, bank lending alone is likely to be insufficient to finance the entire transaction. As such, it is common for sellers to finance a portion of the purchase price. These seller notes are typically subordinated to senior bank lending, and often have provisions that require the seller to remain involved in the business through repayment of the senior debt. If a key motivation of the seller is cash proceeds up front, or if the seller is not willing to stay on with the company following the sale, an ESOP may not be feasible or changes to the structure may be required.
Management Incentives/Synthetic Equity
It is common for sellers to want to ensure that key management of the company is adequately rewarded/incentivized to drive growth in the business following a transaction. To this end, ESOP transactions often include a provision for management incentive plans or synthetic equity (options, stock appreciation rights, etc.) that provide these key individuals with a benefit that exists above and beyond their ESOP ownership.
The above is a sample of issues a seller should consider in the evaluation of a potential ESOP for their company, and many other factors warrant consideration when comparing an ESOP to other means of ownership transition. Please contact GBQ Consulting’s ESOP professionals for questions regarding the feasibility of an ESOP for your company or any other form of ownership transition that you may be considering.