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CEOs

Leaving a Legacy: Why Some Sellers Choose ESOPs

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While Employee Stock Ownership Plans (ESOPs) have long been good exit options for smaller companies, in the last few years larger middle market businesses have started considering ESOPs as an exit strategy as well. Companies worth hundreds of millions of dollars that could have easily sold to private equity firms have opted to go the ESOP route. An ESOP allows employees to buy an interest in a company while at the same time giving the owner liquidity.

Alberto Toribio del Pilar, a managing director with the St. Louis, Missouri-based boutique investment bank ButcherJoseph believes owners of larger companies are more frequently considering ESOPs because they are becoming a more proven way to realize meaningful value at closing while implementing a significant employee retirement benefit.

As a firm, ButcherJoseph has a niche focus on ESOPs. The key tax advantage of this exit option is the ability for a seller (under the right circumstances) to defer capital gains tax on the sale of their business to an ESOP. ButcherJoseph works with sellers to figure out how to best structure their deal to get those tax advantages based on the market value of the business. These types of deals require the business to borrow money — usually against the assets or cash flow of the business — which is why companies with many assets to borrow against or healthy margins are typically a good fit for an ESOP exit strategy.

For example, Nation Safe Drivers (NSD), a roadside assistance company, recently completed an ESOP in Boca Raton, Florida with ButcherJoseph’s help. “We explored several exit strategies, and we were by far the most intrigued with Employee Stock Ownership Plans. Our company has tremendous potential, and we wanted to share this future success with the dedicated employees who will continue growing NSD,” said Andrew Smith, NSD CEO in the press release.  

Leaving a Legacy

At first glance, the clear tax advantages of an ESOP exit option for business owners seems like reason enough to pursue this option. However, tax benefits are rarely the only reason sellers pursue this option.

“Maximizing cash at close is typically not the most important element of the deal for sellers in most of these cases, because these folks already have money,” says del Pilar. “They think about the ESOP structure because it’s an amazing opportunity for their employees.” ESOPs are not often the most lucrative option for the seller. First, while offering fair market value, ESOPs typically cannot match the high multiples offered by private equity firms. Sellers of an asset-heavy business could also see a bigger return by dissolving the company and selling off the assets.

But for business owners who have put their blood, sweat and tears into building a company for many years, money isn’t necessarily the only factor when it comes time to exit.

An ESOP allows employees to secure a portion of their retirement investment through their work and ownership. For example, ButcherJoseph worked with a 35-year-old Midwest-based aviation business on an ESOP.

The business could have sold off its assets, which were worth more than the business as a whole, but the owner wanted to make sure his employees were taken care of. He was a highly-regarded figure in his community with family in the business along with tenured employees and a large technical group of mechanics who took care of the aircrafts. He didn’t want his company bought and relocated. For these reasons, selling his business to a private equity firm or competitor was not an option.

The owner of the business worked with ButcherJoseph for several months to structure the deal. This involved working out management incentive plans to create an environment for performance and ensuring the owner would receive a certain amount of income after close. After the seller realized value at closing, he positioned himself as a creditor by providing seller financing. As a lender he receives principal and interest for the remaining value of his business at closing.

Potential Risks

Typically, ESOPs work best for companies that have strong, tenured management teams that can run the business efficiently after the owner exits. Additionally, companies should have a good collateral base with healthy margins to borrow against for the ESOP structure. The underlying business should be relatively solid and not subject to peaks and troughs.

While ESOPs are good exit options for many, deals can go wrong if they’re not structured correctly. If the deal is done at too high of a valuation, or companies violate covenants with lenders, the deal can go south. Finally, selling the business, but not transferring control is also a way to run a foul with the rules and regulations governing ESOPs. A true board or voting mechanism needs to be put in place to ensure proper corporate governance.

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