When it comes to transitioning yourself out of your company, one option is selling the business to employees. A method of doing this is by setting up an Employee Stock Ownership Plan (ESOP). Although the implementation can get complicated, an ESOP can offer owners and employees many benefits over other stock buyouts. Let’s dive into the pros and cons of ESOPs as a way to sell your company.
After I mentioned Employee Stock Ownership Plans in Article #29 of our Building a Sellable Business series, many people reached out to me and asked for more information about ESOPs. Because this topic is so complicated, I asked a friend of mine, Ben Wells, who specializes in stock buyouts to help me educate you on the topic.
In 1974 Congress was looking for ways to help regular, rank and file employees accumulate wealth. Their idea was to give tax advantages to business owners willing to sell their business to their employees. The Employee Stock Ownership Plan was born. It would promote the spread of wealth among the working class and give business owners a great opportunity to sell in a very tax-advantaged way.
Since the implementation of that Employee Retirement Income Security Act (ERISA) law, ESOPs have become more and more popular as people find out what a great deal they are for employees AND for business owners who want to sell their business.
Although their popularity is growing I don’t believe it’s as widely known as it probably should be. There are currently around 10,000 of these unique options in the United States, with new ones forming all the time. Occasionally, some are terminated when a business sells to a larger company, but they’ve been very popular.
Part of the reason they aren’t being used more is that business owners in general just don’t know enough about them. Some organizations do promote them and encourage owners to establish ESOPs. However, Mergers & Acquisitions advisors, investment bankers, and business brokers tend to promote asset sales to strategic or financial buyers rather than stock buyout options to avoid complexity or to receive payment for their services quicker.
All kinds of businesses can be good candidates. Businesses like architectural and engineering firms, manufacturing companies, government contractors, and almost any business you can think of are candidates for ESOPs.
But they must have a few basic circumstances. First of all, the business has to be able to support some leverage because the business takes on debt at the time the ESOP is established. Therefore, the business needs to have a fairly steady cash flow. It needs, of course, to be profitable.
Having strong employment and management structures also help businesses establish ESOPs. A business that operates as a one-person shop tends to be a poor candidate for an ESOP. Ultimately, the goal is to transfer ownership to employees as the original entrepreneur or the current business owner retires. With an ESOP in place, the business owner can continue to work in and exercise some control over the company for several years after retirement. But ultimately, you need that next generation in place to take over as the selling owner becomes less and less involved.
Additionally, an eligible business needs to have earnings (EBITDA earnings) substantial enough to employ 15-20 or more employees. If the business has fewer than 15 employees an ESOP is possible, but they are fairly complicated to set up. Therefore, they’re not good for your little mom-and-pop corner businesses. Your business revenue needs to be high enough to support a significant number of employees who can purchase the amount of stock you want to sell and who can come in and run the business successfully at some point.
It’s actually a bit of a misnomer to call it an Employee Stock Ownership Plan. Technically, the employees don’t own the stock.
When owners sell the company to an ESOP, they essentially sell to a retirement plan like a 401(k) plan. In reality, an ESOP is an organized retirement account held by a trustee for the benefit of a company’s employees. When you sell your business to an ESOP, you’re really selling it to a trustee. That person, or trust company, will negotiate the closing deal on behalf of the employees and hold the sold stock in trust.
So even though employees have an ownership stake in the company, they don’t have a right to vote their shares. Neither do they get to elect the board of directors or say how the company should be operated. However, they get the benefit of owning the shares. When the employees retire, then, they get a payment based on what the shares are worth.
Essentially, that’s how the deal gets done. As a business owner, you get to pick the trustee who will control the trust. Usually, you and your exit team will interview several and pick the most compatible one. Then, you’ll negotiate a deal with the trustee. If you want 10 million dollars (or any other particular amount) for the business, you’ll negotiate just like you would in any other business sale.
You may say, “I’ll sell the business for 12 million.” The trustee could come back and offer you 8 million. Ultimately, you agree on a purchase price of 10 million. At that point, the trustee owns the business. Under the agreement, though, you’ll still have the opportunity to run the business for as long as you want to stay around. The trustee likes that because he doesn’t want anything to happen that could decrease the company’s value.
Very seldom will you walk away with 10 million dollars if you sell your company to an ESOP for 10 million. Instead, you can structure the payment in two different ways:
It’s worth noting that if you sell your company to an ESOP, and the ESOP elects an S Corporation status, the income of the corporation passes through to the ESOP. The ESOP is tax-exempt. So it doesn’t pay any tax after the ESOP buys the business. Basically, then, you’ve freed up all of the company’s income from any type of tax obligation. That means there’s a lot more cash available to pay you as the owner.
In an ESOP transaction, often the amount of money a company saves in taxes is enough to buy the business from the owner. So from a cash standpoint, it can be a great device as long as the owner doesn’t mind being paid over 4, 5, 6, or more years instead of getting everything at the closing.
RELATED ARTICLE: Options of Selling Your Business that Minimize Negative Tax Implications
Business owners choose an ESOP if they:
If your goal is to sell your business right now, move to an island in the Caribbean, and never think about work again, you’re probably not a great candidate for an ESOP.
Business owners who choose an ESOP are typically about 10 or 15 years from retirement. They want to stay involved in the business for a while, but they want to take a little money off of the table. They have time to wait for payment from the sale over a period of years. If you don’t want to wait for your money, or you can’t wait for your money, this option is probably not right for you.
For other payout options, check out our RELATED ARTICLE: Top Five Ways of Getting Paid When Selling a Business.
Not necessarily. It depends on how they structure the sale. Without getting into too many details, a business owner can sell to an ESOP but still participate in the growth and value growth of the business.
As part of the sale’s financing, the company can give warrants to the owner. Essentially, a warrant is the same as a stock option in that the owner gets a right to share in the growth in value of the stock over time. So if you get warrants as part of the financing and the business goes up in value, you’ll get some of that. You’ll have to share it with the employees, of course, because they also own an interest in the business. But if an owner wants to continue to be involved, run the business, and get the right to participate in that upside, he’ll be able to do it.
Yes, it is a complicated transaction. There are a couple of sets of lawyers, bankers, a trustee, and a valuation firm involved. All of those people get paid, so it’s not free, or even cheap. But, when you compare it to the cost of other types of sales, like a leveraged recap or one involving an investment banker, it’s comparable.
There’s no free lunch on any of this stuff. However, because of the significant tax advantages involved, we find that an ESOP, in the long run, competitively produces some great results for business owners. I’ve seen many examples where business owners compared a sale to a financial buyer, a sale to a strategic buyer, or a sale to an Employee Stock Ownership Plan. In many of those cases, the ESOP comes out not just a little bit on top, but way on top.
Absolutely. Since the ESOP-world is a small one, it’s really a national practice. We’re dealing with federal law, not state law, for the most part. Thus, expertise transfers across the country. However, if a corporate or real estate issue involves state law, firms can always hire local counsel.
With that said, we wrap up our interview with Ben Wells. If you would like to discuss ESOP pros and cons – whether or not your business would be a good candidate selling to employees, you are welcome to contact Ben through his firm’s website. And be sure to visit our Building a Sellable Business blog/podcast series for more helpful content helping you get the maximum amount for your business when you retire.
Special thanks to Attorney and fellow exit planner, Ben Wells for helping me break down the details of ESOPs. Ben is an attorney (so don’t hold that against him 🙂 ). He practices law in the Cincinnati area, and he’s special because he’s also a fellow CEPA® and is the perfect example of a razor-sharp attorney I talk about in my article, What a ‘Sharp’ Attorney Brings to a Good Business Sales Contract.