As the owner of a successful privately held business, you’ve worked hard to get to where you are. When it comes time to make plans for your future and that of your business, there’s a lot at stake.
Determining the right business succession strategy requires complex decision-making, careful analysis and good advice. The needs of multiple parties must be taken into consideration, as the decision affects the future of the company and its employees, as well as you, your family, your legacy, and your role in the company going forward.
An Employee Stock Ownership Plan (ESOP) is an ownership transition strategy in which exiting owners sell their ownership interest to an ESOP instead of a third party. The ESOP gives current owners flexibility and control in the business succession process, as well as an immediate market to which they can sell their stock. Here are some questions to ask yourself, to determine whether an ESOP is the right transition strategy for you and your company.
Does an ESOP meet my key objectives for the transition?
Every business owner has different priorities for their ownership transition, and each business transition strategy serves different objectives. An ESOP may be the right transition strategy for a business owner who wishes to achieve the following objectives:
- Save tax dollars. ESOPs offer unique tax benefits to both sellers and the company alike. For example, if an ESOP acquires C-Corp shares, the seller may take advantage of Section 1042 rollover to defer tax on the sale of stock to the ESOP, as long as the proceeds are reinvested in qualified replacement property and certain requirements are met.
- Maintain control in the succession process. Compared to other transition alternatives, an ESOP gives selling owners greater control over factors like the timing of the transaction, the structure of the transaction, continuity of the management team, and their own role in the company going forward.
- Continue their involvement and legacy. A selling shareholder could sell only part of their shares to the ESOP now, and the rest later. This allows the seller to realize some liquidity now, maintain their involvement in the business, and retire (sell the rest of their shares) when the timing is right. By staying involved in the company, the selling owner has more opportunity to influence the company’s future, strategic direction and legacy.
- Protect their employees. In a third-party sale, an outside party takes over company management and operations, which could result in drastic changes in company culture and leadership. An ESOP protects employees from such disruptions, while also providing ownership stake and a valuable retirement benefit.
Conversely, if a business owner’s priorities lie within the objectives listed below, an ESOP may not be the best transition strategy to meet their needs:
- Maximize purchase price. Under Federal law, an ESOP sale is restricted to “adequate consideration” (fair market value) for company stock. If there was a synergistic buyer in the market, it’s possible the seller could get a higher purchase price than what an ESOP is allowed to pay.
- Ensure a quick payout of purchase price. In most cases, a third-party buyer will offer payment terms that result in more immediate payment of the full purchase price—allowing the seller to be paid in full within a few years following the transaction. This is not always the case with ESOP transactions, which typically have a longer payback.
- Achieve high liquidity at close. In an ESOP transaction, liquidity is typically created by the company borrowing from a lender to finance the ESOP’s stock purchase. Lenders’ requirements limit the amount of debt an ESOP can have on the balance sheet; because of this, the seller will likely receive less cash at close and will maintain some form of investment interest in the business for several years post-transaction.
Is my company a good candidate for an ESOP?
Numerous factors make a company a suitable candidate for an ESOP. First and foremost, the company must be in a strong financial position to ensure that they can meet the immediate and future financial obligations of the ESOP (more on this below). This is also important because the performance of the ESOP company determines the value of shares, and hence, the value of the employees’ retirement benefit.
The company must also be the right size. Employee demographics—such as the number of employees, level of payroll compared to company value, turnover rates, and average age of employees—impact the ESOP’s financial feasibility. While there is no required number of employees an ESOP company must have, there must be enough employees to ensure the costs of the plan don’t outweigh the benefits, and that the plan remains within IRS parameters which limit annual contributions to individual accounts. Generally, companies with more employees also benefit from economies of scale when it comes to ESOP costs.
A strong ESOP candidate also has a culture of ownership. Management must not only be able and willing to take on the legal, administrative and financial requirements of the plan, but they must also be dedicated to empowering and educating workers to become knowledgeable employee-owners. The company culture must foster communication and employee participation. Employees must be open to ownership and engaged in the success of the ESOP, knowing that their contributions influence their own financial success.
Industry also influences the ESOP’s likelihood of success. For example, companies in labor- or people-intensive industries may find an ESOP beneficial due to its potential to enhance productivity. Conversely, companies in industries that have a high risk of obsolescence may not be suitable ESOP candidates, as the ESOP is designed for longevity.
An ESOP feasibility study takes all these factors and more into account, to help selling owners determine if their company is indeed a good candidate for an ESOP.
Can my business meet the financial obligations to support the ESOP?
A strong history of profitability and a high potential for future success are essential to cover the initial costs of ESOP implementation, as well as the ongoing financial commitments in the future. Before implementation, an ESOP feasibility study helps determine whether the company has the financial resources to implement, sustain and properly operate the ESOP.
Initial ESOP setup includes several significant costs. The company will need to hire outside accounting and legal services to advise on ESOP terms and financing, prepare and effect documents, and more. The company must also engage an independent ESOP Trustee, who is typically an external party. In addition, an independent appraiser (valuation firm) is engaged by the Trustee to support the stock price at which the ESOP transaction is entered.
After the ESOP is established, the company must cover ongoing annual costs including the valuation fees, audit fees (for ESOPs that have 120 or more participants), tax return preparation fees, and plan administration. Additionally, the company must have strong cash flow to ensure:
- Contributions to the plan will be able to be made
- Distributions to plan participants leaving the plan will be able to be funded
- The ESOP repurchase obligation can be met
ESOP repurchase liability studies help the company quantify their repurchase obligation and determine whether it can be met, while sustainability studies help leadership identify strategies to manage the ESOP and achieve strategic initiatives in the long run.
Do I have a strong successor management team who is ready, willing and able to deal with the complexities of the ESOP?
Though ESOPs offer significant advantages, they are also complicated and require expertise, time and attention to be successful. Even if you have external advisors and an external trustee, you need a leader within the company to develop enough expertise to ensure the right information and assistance is provided to all parties involved. The leader should be responsible for communication, education, and advocacy of the plan, while ensuring compliance with the strict legal and financial obligations. ESOPs are strong motivators for productivity, but only if management fosters an employee-centered culture where the entire team understands the benefit and is devoted to the success of the company and the ESOP.
Helping you get there…
An ESOP, when suitable, may bring significant advantages to all parties involved in the business succession process. With careful consideration, planning, and the right advice, a selling business owner may find an ESOP to be the transition solution that helps them achieve their personal objectives, while setting their company up for future success. To learn more about whether an ESOP is the right transition strategy for you, and how we can assist with our ESOP advisory services, connect with us today.