Savvy business owners seeking liquidity are increasingly benefitting from ESOPs. While providing a valuable benefit plan to attract and retain employees, the strategy also offers substantial tax savings. Currently, there are over 11,000 ESOPs employing more than 13 million in the U.S., and growing. They include many well-regarded companies across industries, ranging from the architectural firm Gensler to the hospital operator Acuity Healthcare. If a company has at least 40 employees with over $10 million in sales and is profitable, an ESOP may be a compelling option to consider.
A Brief Primer. An employee stock ownership plan (ESOP) is an employee benefit plan, not unlike a pension plan, that benefits the employees and the selling shareholder. An owner can sell some or all of his shares to an ESOP trust which owns the shares on behalf of employees. An ESOP can be funded through company profits and proceeds from a loan. (Typically, the company takes out a loan and then loan the funds to an ESOP trust.)
Substantial Tax Benefits. Owners selling to a leveraged ESOP may realize over 40% more after-tax proceeds than a traditional LBO. For owners of a C corporation who sell more than 30% of the value of their company, all taxes on capital gains are deferred, provided that the proceeds are reinvested into stocks or bonds of a U.S. company. Further, contributions to the ESOP are tax-deductible, as are payments by the company to pay off principal from the ESOP debt, and dividends paid to the ESOP. (1) These deductions reduce and may eliminate corporate income taxes. For S corporations, the portion or earnings attributable to the ESOP is not subject to federal income tax. So an S corporation owned entirely by an ESOP pays no federal tax, which boosts cash flow available to service debt, grow the business, or pay interest to investors.
Aligning Interests with Employees. Companies in which employees have a real ownership stake experience greater productivity, higher profitability, and lower turnover than comparable private firms that are not employee-owned. Employees who are shareholders have a vested stake in the success of the company, which is even more striking today as many companies have eliminated or rolled back pensions and 401(k) benefits. Using an ESOP can also be part of a succession strategy and a means for business owners to preserve their legacy.
Ample Financing Available. While financial institutions ranging from money center banks to community lenders have been the mainstay of funding ESOPs, others, attracted to the frothy cash flow from ESOP-owned companies, have entered the market. Finance companies have opened up dedicated units to provide junior capital and unitranche facilities to support ESOP buyouts. Also, several private equity firms are actively investing in ESOP transactions in the form of a structured security with a current yield and equity participation.
Flexibility of Structure. Business owners can choose when and how many shares to sell to an ESOP. An owner may choose to prefund an ESOP, benefit from the tax deduction, and soon after sell shares at higher prices as the company grows. Alternatively, an owner may seek a complete sale which can be accomplished through bank/investor debt and a seller note. Transactions can be structured to provide an opportunity for the selling shareholder to retain as much as 30% to 40% ownership, which provides a future opportunity to sell— the “second bite of the apple.” (2)
Operating an ESOP. For all practical purposes, business owners typically retain operating control following the sale to an ESOP, and may serve as the trustee of the ESOP trust. Alternatively, the company’s board may select a representative from a local trust company. The trustee is a fiduciary and has responsibility for acting in the best interest of the plan participants, and may need to recuse himself if there is a conflict of interest. Costs for setting up an ESOP are typically less than selling to a third party, and there are other costs for an annual valuation and administration.
How to Get Started? Owners seeking liquidity should consider a range of options to achieve their objectives. Consider engaging an investment banker with the specific expertise and experience to prepare a company for a traditional sale process, as well as to evaluate the benefits of ESOP structures and financing alternatives. Counsel experienced in advising business owners on all the facets of an ESOP transaction are invaluable, and should be engaged early in the process.
(1) Annual contributions to an ESOP are limited to 25% of eligible payroll.
(2) A selling shareholder may be able to realize substantial ownership through (i) participation in a management incentive plan; (ii) an equity kicker (warrants) providing additional yield on a seller note; and (iii) in certain cases, as part of an earn out.