Since 1974 when Congress first created the tax incentives for employees to become shareholders with the creation of Employee Stock Ownership Plans (ESOP), nearly 14 million employees own stock in over 7,000 companies through ESOPs. It ranges from companies as large as Publix Supermarkets with over 190,000 employees to relatively small companies with just $1 million in annual payroll.
Despite the growing popularity of ESOPs and the significant tax advantages many misconceptions exist so it’s difficult for a business owner to make an informed decision about setting up an ESOP for their company, and its employees. Let me attempt to dispel ten common misconceptions, or fables, about ESOPs.
ESOP Fable #1: It would be easier just to sell my company to a third party.
Business owners frequently hold the belief that “When the time comes to retire, I will just sell my company to an interested buyer.” As if that’s all there is to it. All you gotta do is……
Unfortunately, it’s not that easy. Finding a qualified buyer who is ready, willing and able to pay a fair price for a privately held business can be a daunting task even in good economic times, and nearly impossible in bad times. Many qualified buyers will require the seller to hold a substantial portion of the purchase price as a seller’s note.
Even if an owner has been approached in the past by parties expressing interests in buying their company, the actual commitment to purchase can often be disappointing. Many of these “interested parties” are hoping to acquire a business at a substantial discount from its fair market value, if they can. Herein lies one of the key benefits of selling your company to an ESOP. There is no need to find a qualified buyer, or to otherwise put your company on the market. Instead of having to find a buyer, setting up an ESOP actually creates the buyer.
Typically, the sale of a business that is structured as a sale of common stock has a lower Federal Income Tax impact on the seller than if it’s structured as a sale of assets. However, most buyers will insist upon the transaction being structured as a sale of assets since it avoids carry over liabilities and has more favorable tax treatment for the buyer. An ESOP transaction can be structured as the sale of common stock if that’s what the owner wishes. Furthermore, the ESOP will pay fair market value for the stock. And, closing the sale can take considerably less time than a typical third-party sale, often less than 120 days. Moreover, the ESOP can acquire some of your stock now (minimum 30%) and when you’re ready to sell more, the ESOP can then buy more. The ESOP can also be established to buy a portion of your company (either control position or not) and the remainder can be transferred to your children outside of the ESOP.
ESOP Fable #2: ESOPs are only applicable to very large corporations.
There is a commonly held notion that the benefits offered by Employee Stock Ownership Plans are available only to the largest of corporations. In reality, most ESOPs are found in companies with fewer than 100 employees. Of course, the larger ESOPs from companies such as Publix Supermarkets, United Airlines and W.L Gore of Gore-Tex get the headlines; but ESOPs can be found in companies with as few as thirty employees. In fact, if you are willing to incur the ongoing costs, an ESOP can be created for a much smaller company.
ESOP Fable #3: If I sell to an ESOP, I will lose control of the company.
A business owner might fear the loss of control after selling to an ESOP. While the ESOP Trustee is empowered to vote all of the shares owned by the plan, in most ESOPs, the selling owner can greatly influence who is selected to be the Trustee and assure that it’s someone in whom you have complete confidence. This means if you sell your shares to an ESOP, you can maintain control of the company, for as long as you choose. With the recent August 2018 changes in the rules, an owner can stay on as CEO or Chairman after the ESOP transaction is complete. Only in certain circumstances, such as the liquidation of the business, do employees individually vote their shares of stock. Thus, the fear of having to consult employees and have them vote on every corporate decision is simply unfounded.
ESOP Fable #4: My employees cannot afford to buy my company.
Another common misconception can be paraphrased as, “How can my employees even consider buying my company…most live paycheck to paycheck.” The answer is simple: The employees do not have to pay for the company. The employees do not contribute personal funds, or even provide credit for the transaction. Funding is provided by specialty lending institutions whose focus may be solely on funding ESOP buyouts.
Over time, ownership is passed from the ESOP to the employees by allocation to their ESOP accounts. The longer the employee remains with the company, the larger will be his or her ownership stake. The ESOP is, in essence, a retirement plan, funded by stock appreciation and company earnings. Ideally, upon retirement and after fully vesting, the shares allocated to a retiring employee are repurchased by the ESOP plan, so the shares can be reallocated to other employees.
The motivational aspects of these plans can be extremely powerful for the employees. In fact, most ESOP companies experience lower employee turnover after implementing the plans; and according to several national studies, ESOP companies tend to be 8-12% more profitable than their non-ESOP counterparts. Perhaps the best evidence of the impact upon employee behavior is to compare your shopping experience at Publix (an ESOP company) and Winn Dixie supermarkets.
ESOP Fable #5: An ESOP won’t pay me what my company is worth.
Most business owners have some idea of what their company is worth. The truth is if you sell your company to an ESOP, you will be paid full fair market value. The determination of fair market value will be made by an independent, certified, business valuation analyst.
In addition to a formal business valuation, a fairness opinion is typically obtained by the Trustee since the business valuation number is based upon being paid 100% in cash at the time of closing for 100% of the shares, assuming the company is debt free. The fairness opinion addresses both the Price and Terms of the proposed transaction.
The business valuation professional uses sophisticated yet standardized techniques to determine the fair market value of a business. Independence of the valuation analyst is required, which effectively removes any biases in favor of either the ESOP or the seller. Therefore, you can be confident of receiving a fair price for your company when selling to an ESOP.
Moreover, by selling your company to an ESOP, you will have the opportunity to structure the transaction so that you can fully defer all income taxes on the sale. Just remember the term “Section 1042 sale.” This means not only will you receive full value for your company, but you might also enjoy powerful tax savings because of selling to an ESOP, which otherwise would not have been available by selling to a third party.
ESOP Fable #6: ESOPs are new and untested.
Because they have not heard of ESOPs before, some business owners are skeptical and consider such transactions to be new and untested. Yet, ESOPs have been around for at least 40 years. The statutory framework for today’s ESOP was developed by Congress in 1974 to broaden the ownership of capital, and to provide employees with a stake in the ownership of their employers. To induce companies to create ESOPs, Congress has developed powerful tax incentives for both existing owners and their companies. The incentives have over the years been enhanced and as recently as August 12, 2018 significant improvements have been made by Congress.
In 1974 there were less than 200 ESOPs. Today there are more than 7,000 ESOPs in place, covering more than 14 million employees.
ESOP Fable #7: Lenders won’t be interested in financing my buyout.
Another common misconception is: “My bank would not be interested in financing the buyout of my business by an ESOP.” As a general rule, conventional business lenders will not be interested in financing an ESOP buyout. This can be attributed to their lack of ESOP knowledge and experience, and to a general reluctance for wandering outside of their core business practices.
If your company is already highly leveraged, it may not be an ESOP candidate. While recent changes in SBA guaranteed lending rules allow the loans to be direct to the ESOP and not on the company’s books, the cash to repay the loans must come from the cash flow from the business. The recent change in the SBA rules makes this exit strategy most attractive for Engineering, Architectural and Design/build companies that have solid cash flow but few tangible assets to pledge as collateral. Typically, when this type of company is sold, any debt placed on the company’s balance sheet can negatively impact the company’s performance bonding level. However, using an ESOP with an SBA guaranteed loan on the ESOP’s books seems to overcome this problem.
Specialty lenders are quite interested in financing ESOP buyouts. We know well several such lenders that in addition to the $5 Million maximum available from the SBA 7A loan, they are able to lay on an additional $5 to $10 million of mezzanine debt. With the owner providing an additional seller’s note, this tool makes a lot of sense for companies worth $5 million to $30 million. It’s all about the reliable cash flow of the business. Reliable cash flow is the major factor impacting the valuation analyst’s determination of fair market value and the reliable cash flow of the company is a major determinant in how much and on what terms lenders will fund the ESOP transaction. In addition, since the seller’s note will be subordinate to all other loans, warrants and phantom stock can be used to enhance the yield on the seller’s note.
Further, the company will have the ability under ESOP rules to deduct from taxes not only the interest paid on the buyout loan, but also the principal payments. This significantly lowers the company’s effective borrowing costs. As a result, the ESOP can be in a better position to buy your shares than a third-party acquirer who will not have access to such favorable tax treatment.
ESOP Fable #8: I fear that my employees can sell their stock to someone else.
Another common fear of business owners considering an ESOP is whether employee shareholders will be able to sell their shares to just anyone on the street. This concern is addressed by specific restrictions placed upon the shares in the employees’ ESOP accounts. Most ESOP plans give the company a specific right and responsibility to repurchase all shares allocated to employees.
What this means is your employees, upon distribution, must sell their shares back to the company (or ESOP). This is the mechanism through which the employees receive their retirement funds; and it keeps shares from falling into the hands of unrelated parties. Typically, all shares are distributed with a back-up liquidity measure called a put. This put provides for the retiring employee to sell (or put) their shares back to the company at fair market value. Both the stock restriction and the put option ensure liquidity for the employee, and protection for the company.
ESOP Fable #9: I will not be able to sell a part of my company, while leaving the other part to my children.
Often business owners would like to leave their businesses to their children; but must also fund their own retirement years. A logical solution would be to sell a partial interest in the company and leave the rest to the children. However, selling a partial interest in a privately held company can be nearly impossible, unless the seller will agree to a steep discount in price.
ESOPs, on the other hand, will allow you to sell an interest in your company to its employees, at fair market value, and gift or sell your remaining interest to your children. Under this scenario, you can decide whether you want your children or your key employees to remain in control of the company, while you receive a lump sum payment for your shares sold to the ESOP.
ESOP Fable #10: An ESOP will remedy all of my company’s problems.
While the Employee Stock Ownership Plan is a powerful tool, it is not a panacea. If your company has fundamental financial, organizational, or operational problems, an ESOP will not likely make it better. ESOPs work best for healthy companies with strong potential for future success.
Likewise, installing an ESOP in a healthy company does not ensure improved performance. In order to realize the greatest performance improvement from an ESOP, the employees must be educated about the benefits offered; and this education process must be ongoing and reinforced regularly. Otherwise, skeptical employees may consider the plan as just another management scheme.
The Employee Stock Ownership Plan has become one of the most powerful vehicles of corporate finance available to owners of privately held businesses. Accordingly, its success can be measured by the rapid growth in the number of plans established, from less than 200 in 1974, to more than 7,000 today. By dispelling some of the most commonly held ESOP misconceptions, and by studying the opportunities offered by such plans, business owners may find that creating an ESOP for their situation offers significant advantages over selling to a third party.
Not an ESOP Fable
Next month our Transworld M&A newsletter will address some of the quirks and things to anticipate when establishing an ESOP. If you don’t wish to wait until next month, just send me an email and I will send you an advance copy. (LRussek@TransworldMA.com)
If you wish to explore the prospects of an ESOP for your company, we will be pleased to meet with you and share our insights on how it might be a fit for your company. We can also introduce you to attorneys, trustees and lenders who are experienced with ESOPs and will be delighted with the prospect of working creatively to establish an ESOP that meets your needs.
- Len Russek, a former CPA has been a Mergers & Acquisitions advisor for over 25 years both inside large corporations and as an intermediary during which he has been involved in structuring and negotiating the sale of hundreds of businesses. Contact him at 727-894-7888 or LRussek@TransworldMA.com.
- Mike Ertel spent the first 30+ years of his career in corporate management with an emphasis in marketing, strategic planning & operations with companies such as 3M, Bemis Packaging, GE Major Appliance, Hillenbrand Industries, Batesville Casket, and Premier Bedding, before founding his own M&A advisory practice in 2000 to assist buyers and sellers in the sale of mid-sized, privately held companies. Contact Mike at 813.299.7862, or MErtel@TransworldMA.com.