When business owners are faced with a decision regarding succession planning and the future of their business there are several options, including: selling to a competitor or strategic buyer, selling to a private equity fund, liquidating the assets of the business, among others. While the sale proceeds may depend on the type of transaction, in each case the future of the business and the owner’s legacy after the transaction is uncertain.
An often-overlooked exit strategy is a sale of the company to an employee stock ownership trust and formation of an employee stock ownership plan (collectively, an “ESOP”). An ESOP is a type of qualified retirement plan that invests primarily in the stock of one company. An ESOP provides business owners with an opportunity to be actively involved in the future of the business and assist in guiding the company to success and preserving the legacy built over many years. We’ve outlined five reasons to consider an ESOP as an exit strategy:
Succession Plan Creation
An ESOP provides business owners with a market for their shares outside of selling to a competitor or private equity fund. Typically, the business owner remains with the company for a number of years and receives value for their shares over a number of years (either through multiple transactions or payments on a seller note) during which they can continue to participate in the operations. The option of establishing an ESOP can be attractive to business owners that may not have an “heir apparent” to acquire the equity of the business or to business owners that are not interested in going through a sale process involving a potential competitor or private equity fund.
An ESOP provides business owners of C corporations (or an S corporation that has revoked its S corporation election) the ability to defer taxes on a sale of equity to an ESOP via a tax election made available through §1042 of the Internal Revenue Code. The seller must reinvest the sale proceeds in qualified replacement property within 12 months of a sale and would be taxed upon disposition of that property. However, if structured properly, the taxpayer may avoid paying all long-term capital gain taxes associated with the sale.
In addition to the tax benefits available to sellers, the company can benefit from tax-deductible contributions to an ESOP in the form of principal and interest payments in a leveraged transaction. If the company is an S corporation and sells 100% of its stock to an ESOP the company and the ESOP typically do not have any income tax obligation – since the ESOP, as the sole shareholder, is a tax exempt trust and S corporation earnings flow through to shareholders, the entity can become effectively tax-free.
Upon the formation of an ESOP and completion of a transaction, employees will receive a tax deferred benefit over a number of years by receiving an allocation of the acquired shares to accounts for their benefit. These accounts are tax deferred and the employees are not required to contribute in order to receive shares. This offers employees of the company an additional benefit that increases employee morale, retention of existing employees, and attraction of new employees.
The sale of a company to an ESOP can be structured in a manner that allows for the acquisition of a minority, majority or 100% interest in the outstanding shares from a business owner. This flexibility allows owners to participate in the potential appreciation of company value if they sell less than 100% or they can sell 100% at a fixed value at one point in time. In order for a shareholder to receive cash for their sold shares, the company will typically obtain outside financing from a lender. Any additional shares sold above the shares acquired with lender financing are typically acquired by utilizing seller financing. If seller financing is utilized, it can provide the shareholder with additional return above the sale price of their shares.
Ongoing Role and Less Operational Interruption
Typically, after a sale a strategic buyer or a financial buyer will spend time on integration and may also engage in cost cutting measures or eliminate positions. After a sale to an ESOP, the business operations can continue uninterrupted and little is changed operationally from before the transaction. Due to a more seamless transition, business owners are often comforted by an ESOP ensuring employees will keep their jobs, receive an additional benefit, and business continues as usual. If a business owner also holds an executive position in the company, by selling to an ESOP the business owner can retain their position, unlike the uncertainty created in a sale to a strategic or private equity buyer.
When business owners are at a point of transition and evaluating strategic options, it is important to consider all options, including an ESOP, in order to make an informed decision regarding the best path forward. Greenwich Capital Group has extensive M&A experience, including ESOP formation and consulting. If you have any questions regarding ESOPs, please contact Brian Hock at email@example.com
 Additional criteria must be met in order to qualify for a §1042 rollover, including the ESOP owning greater than 30% of the stock, ownership of equity must be for a period of at least three years prior to sale, and specific qualified replacement property categories must be met, among others.