When going through an ownership transition, an owner has several options: create liquidity via a leverage recapitalization using a debt funded dividend to owners; sell control to a strategic or financial buyer; or sell a minority or majority stake of the company to an Employee Stock Ownership Plan (ESOP).
“An ESOP is a qualified retirement plan designed to give employees an economic interest in their employer stock,” says Jim Altman, Middle Market Pennsylvania Regional Executive at Huntington Bank. “ESOPs are the only retirement plan allowed to borrow money to purchase employer stock. Once purchased, the employer stock is allocated to accounts for individual participants so that, when they retire, they can either receive cash or shares, which are then sold back to the ESOP.”
Altman says an ESOP is considered a Qualified Defined Contribution Retirement Plan that is invested primarily in company stock. It’s a flexible tool for owners to sell all or part of a privately held business.
“In this arrangement, the business owner controls the timing and extent of his or her exit, but may still maintain company control or use the tax advantages to help fund its sale.”
Smart Business spoke with Altman about ESOPs and the potential benefits the structure provides owners and their companies.
Who typically uses ESOPs?
ESOP plans work best for companies with:
- Strong cash flow.
- A history of stable sales and profits.
- Taxable income.
- A capable management team in place that will remain after the sale.
- An owner who has a significant portion of his or her net worth invested in the value of the business.
- Valuable employees.
A company should be closely held, have EBITDA in excess of $3 million with an annual payroll of $1 million or more and at least 30 employees. The structure works particularly well for businesses in manufacturing, financial services, professional services, wholesale trade and distribution.
What advantages does an ESOP offer?
An ESOP is a tax advantaged transfer of ownership. The seller’s proceeds can potentially be tax-free via 1042 rollover. There are income and estate tax savings for sellers, management and the company. If the business is structured as a 100 percent ESOP-owned S-Corp., the company will not pay federal income tax.
Also, an ESOP can deduct the transaction price over time, enhancing cash flow and improving credit metrics.
Among the advantages to a seller when transferring ownership to an ESOP is liquidity — the seller gets more money after tax for the sale of closely held stock than for the sale of assets to a third party. The seller enjoys a rate of return via the seller notes, which is far superior to any return available on an alternative investment with fully understood risk and within the seller’s control to manage.
Selling to an ESOP offers flexibility as an owner may sell between 30 to 100 percent of the shares either all at once or gradually over time to accommodate multiple seller exit scenarios. It also creates the option for the seller to maintain control over his or her company, or allow the previous management team to maintain control and management of the company. Warrants and stock appreciation rights may be used to provide incentives to key managers.
How does the transition affect employees?
Forming an ESOP is a good way to protect the jobs of employees, which otherwise may be lost in a sale. Employee-owned companies experience lower turnover, less absenteeism and higher productivity, while employees receive higher pay, better benefits and report better mental health.
Once in place and acquisition debt is paid off, employees tend to not only be more productive, but they are more careful with expenses because they are invested to improve the company’s performance for their own benefit.
Constructing an ESOP is complicated and requires knowledgeable professionals to close. They’re also not for everyone. Owners should spend time with their banker to learn about ESOPs before moving forward. ●
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