Article written by:
Joe Borowski, CFA
Director, Valuation & Financial Opinion Services
An Employee Stock Ownership Plan, or “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, while at the same time providing an attractive business succession plan for selling shareholders. As “baby boomer” business owners reach retirement age, many have sold their businesses to their employees through an ESOP. There are over 6,000 ESOPs in the United States, and the number of participants in ESOPs has grown in recent years (source: National Center for Employee Ownership, “NCEO”).
While ESOPs continue to grow in popularity, they are not ideal for every ownership transition situation. In the common scenarios below, I describe why an ESOP may not be a good fit, and provide an alternative solution:
- Company’s future free cash flow is limited. Most companies take on leverage to enable the ESOP to purchase the shares from selling shareholders. This debt must be repaid, typically over five or ten years. Companies with near-term cash flow constraints caused by low profitability, pre-existing debt payments, capital needs, etc., may not be able to take on this ESOP debt.
- Alternative solution: strive to reduce company debt, creating options to pursue ESOP or external sale at higher equity value.
- Company has many potential “strategic” buyers. A healthy economy has spawned an active merger and acquisition (“M&A”) environment during the past few years, as profitable companies look to deploy retained profits. When acquirers are able to realize synergies in acquiring a target (through greater sales, elimination of redundant expenses, lower competitive pressures, etc.), these “strategic” buyers may offer a higher price. Conversely, the ESOP is essentially an “internal” buyer that does not bring any synergies. In fact, valuing a company in the ESOP transaction as if those synergies will exist is an invitation to scrutiny and possible litigation from the Department of Labor (the governing body that ensures ESOPs do not overpay when buying company stock). Therefore, in industries with many potential strategic buyers, an ESOP sale may only be an option if the selling shareholders are willing to accept a purchase price lower than what an external strategic buyer can pay. We note shareholders may be willing to accept this if the tax benefits of selling to the ESOP make up the difference.
- Alternative solution: sale to a strategic, third-party buyer.
- Company has inadequate management depth. As mentioned above, the ESOP is essentially an “internal” buyer, so unlike in a merger or sale, there are no new employees that join the company in an ESOP sale. Further, although an external trustee is often hired to be the fiduciary of the ESOP plan, the trustee typically acts more as a “passive” investor, rather than taking an active role in company management. As such, if the selling shareholders wish to leave the company post-transaction and there is not a reasonable succession plan in place, an ESOP sale may not be feasible.
- Alternative solution: sale to a strategic, third-party buyer.
- Company has a few extremely key managers. ESOPs are designed to provide ownership on a broad scale, and employees typically only have to meet a few requirements to qualify for share allocations. Further, ESOPs must pass certain tests to ensure that a disproportionate share of ownership is not going to a select few (highly compensated) individuals. As such, in situations where the company is (or will be) led by a few critical individuals, for an ESOP structure to work, those individuals will have to be compensated by other means (non-ESOP shares, synthetic equity, other compensation).
- Alternative solution: management buy-out, or sale to a third party strategic buyer.
- Company is small. There are transaction costs to implement an ESOP transaction, which, while often lower than the costs to sell to a third party, can be burdensome for smaller companies. Further, there are also ongoing administrative costs to maintain the ESOP, including trustee, legal, accounting, and valuation fees. Once a company reaches a certain size, the income tax savings under ESOP ownership will likely more than offset the increased administrative burden.
- Alternative solution: sale to a third party buyer, or set up a worker cooperative.
Conclusion
If none of the above scenarios apply, perhaps an ESOP can be a true “triple-win” for the company, shareholders, and employees. ESOPs can be an attractive option for selling shareholders when they:
(a) are ready to achieve liquidity for their ownership and diversify their wealth;
(b) are capable of realizing certain tax benefits not available through a third-party sale;
(c) wish to preserve the company’s legacy as an independent company;
(d) wish to reward their employees who helped build the company; and/or
(e) desire to sell the company in a manner that typically provides greater certainty of closure, with less time and cost.
Please contact us to learn more about whether an ESOP may be the right fit for your company.
