In this podcast, we look at the fundamentals of ESOPs, their benefits, drawbacks, and when and where they are a good fit for a business owner who is seeking a transition of ownership.
ESOPs offer business owners a viable exit strategy, especially if they do not have a clear succession plan. By selling their shares to the ESOP, the owner can gradually transition out of the company while affording themselves and the company certain tax benefits depending on the structure and the specific circumstances. In some cases, the sellers capital gains taxes can be deferred or even eliminated.
For many owners, the preservation of legacy, culture, and values are also highly important considerations. ESOPs often help preserve the company’s mission and vision since the employees become more involved in decision-making and overall operations. With a tangible stake in the company’s success as partial owners, employees have the potential to benefit directly from the company’s growth and profitability. This can serve as a strong incentive for employees to work harder and more efficiently.
By selling to a trust for the benefit of their employees, business owners can enjoy significant tax benefits, preserve the company’s culture, and experience a less intrusive sale process.
What Is an ESOP?
An ESOP is a qualified retirement plan created through the Employee Retirement Income Security Act (ERISA) in 1974. It’s considered a tax-qualified defined contribution retirement plan under IRC §401(a) and operates under similar rules as a 401(k) plan. ESOPs are designed to invest primarily in employer securities, offering a unique opportunity for business owners to create a buyer for their company stock at fair market value. Money can be borrowed from the sponsoring company, its shareholders, or third parties to purchase stock.
The Benefits to ESOP Structure
There are many benefits of an ESOP to both the company and its stakeholders. This is why some business owners use an ESOP as opposed to a third-party sale.
Flexibility
ESOPs offer flexibility because the transaction can be structured as a complete 100% sale to the ESOP or a minority sale, such as 20%, 30%, or 40% of the company’s stock. They also cater to multiple shareholders with different objectives. For example, if one partner wishes to exit the business while the other intends to stay, an ESOP can facilitate a tax-efficient partner buyout, benefiting both the remaining shareholder and the employees.
The financing options for an ESOP are flexible and diverse. Pre-financing is an option, where contributions are made to the trust and the trust acquires the company’s stock, allowing the company to receive a tax deduction. The seller can also finance some or all of the transaction and bank financing or mezzanine financing may be involved to provide more liquidity at closing.
ESOPs offer maximum flexibility in terms of structure, financing, and timing. They are generally quicker to complete compared to third-party sales, and the seller can strategically time the transaction’s closure for optimal tax efficiency or other reasons that serve the interests of all parties involved.
Cost-Effective
An ESOP proves to be a more cost-effective option compared to a third-party sale. The associated fees are generally lower than those incurred in a third-party sale and the process is less intrusive, as the buyer is essentially a passive participant. This means they don’t conduct the same level of exhaustive due diligence that a third-party buyer might, which often involves customer visits, competitive analysis, and extensive interactions with the leadership team. These aspects can be stressful for sellers, especially when confidentiality is crucial or when they haven’t disclosed the process to many of their employees.
Less Risk
ESOPs are characterized by lower risk compared to other transactions. While certain challenges may arise in ESOP transactions, they are generally more manageable and less likely to derail the entire process, unlike in a third-party sale. One of the reasons for their lower risk is that ESOPs cause less disruption to the company’s operations since there’s no need to engage with multiple potential buyers, as is often the case in third-party sales. In a third-party sale, a company may hire an investment banker to initiate an auction, resulting in the disclosure of sensitive information to numerous private equity funds and strategic buyers. These potential buyers may require extensive management interviews and confidential data before deciding to make an offer or decline the deal. Such information disclosure is more limited in an ESOP, making the process smoother and less disruptive.
It’s worth noting that ESOPs can be more intricate from a regulatory and compliance standpoint. Nevertheless, with the assistance of a competent team of advisors, these complexities are effectively navigated and fairly easily overcome.
Tax Efficient
ESOPs offer tax advantages for sellers, the company, and employees. Sellers often choose ESOPs due to the tax benefits that fall into three main categories: for the selling shareholders, the company, and the employees.
Selling Shareholders
Generally speaking, a well-structured ESOP transaction allows the sellers to avoid capital gains taxes if the seller is willing to reinvest the proceeds into a qualified replacement property. This is not just a deferral of the tax on the gain from the sale, but it can be the permanent avoidance. These instruments are known as floating rate notes and the proceeds get reinvested in these instruments. The instrument remains in place for a long period of time, such as a 40 or 50 year bond. When the selling shareholder passes away, their estate receives a step-up in basis further facilitating the avoidance of the capital gains taxes. It’s a significant tax advantage for a selling shareholder.
The Company
From the company’s perspective, contributions made to the ESOP are tax-deductible and used to pay down the inside loan. This effectively creates a deduction for the principal repayment on the transaction value that’s paid. There’s a nuance in how that actually happens, but at the end of the day, the company gets a deduction for the principal repayment, a benefit rarely seen in other transactions.
When an ESOP leads to the company becoming 100% owned, and if the company is structured as an S-corporation, the company basically pays no corporate income tax. The income flows through to the ESOP, which is a tax-exempt entity, resulting in the company becoming virtually tax-free, except for a small tax in certain regions, such as California where a corporation in that state pays 1.5%.
Employees
The employees, who are ultimately going to receive the benefits, can defer the tax on their benefits until they make withdrawals from, for example, a rollover IRA. The same rules that apply to a 401(k) plan apply to ESOPs from the standpoint of the employees actually realizing their benefits.
Preservation of Culture
A significant reason why many companies choose to implement ESOPs is their ability to maintain and preserve their unique organizational culture. This is due to the fact that the ESOP trustee, who holds the shares on behalf of the employees, becomes a passive shareholder. There is no active involvement from an external buyer. There isn’t a private equity fund asking for quarterly reports and monthly phone calls. They don’t have a strategic buyer that’s looking for them to cross sell products and manage them from that perspective. By adopting an ESOP, companies can achieve remarkable tax efficiency while ensuring continuity in their culture, ownership structure, and reporting practices. The transaction allows them to benefit from tax advantages without compromising the essence of their organization so they sustain their identity and values.
Improved Company Performance
In many cases, we observe a noticeable improvement in company performance following the implementation of an ESOP. Why does it improve? Because all employees become beneficial owners and the performance of the company directly influences the amount of their benefit or the value of the company. As employees realize that their efforts contribute to the company’s growth, efficiency, and waste reduction, and that they are building their own wealth rather than just enriching someone else, a positive impact on company performance emerges.
It’s important to note that this improvement doesn’t happen automatically. It requires careful nurturing and attention. ESOPs serve as an augmentation and enhancement to the existing company culture rather than a replacement for it. While the ESOP structure fosters a sense of ownership and motivation among employees, it’s essential to sustain and support this cultural transformation to fully harness its benefits.
Meaningful Wealth Creation for Employees
Extensive research and our own findings consistently show that employees benefit greatly from ESOP ownership, often surpassing the wealth accumulation achieved through their 401(k) plans. In numerous instances, ESOPs yield a retirement balance multiple times higher than that of traditional 401(k) plans. This creates a win-win.
Attractive Rate of Return on Seller Financing
Another benefit for sellers, which some may perceive as a drawback, but we view as a potential offset, is that ESOPs are leveraged transactions involving debt. This debt can come from a bank, a private equity fund through mezzanine financing, or from the seller directly. While financing the ESOP purchase does involve some level of risk for the seller, the risk is measured and the seller is compensated for taking that risk.
To compensate the seller for taking on this risk, an increased rate of return on the financing is often offered. For example, the seller may receive a higher interest rate, such as 6% or 7%, on the loan they make to the ESOP or they may receive a higher interest rate plus a number of warrants, which are a claim on the future value of the company, to make up the shortfall. This is a form of synthetic equity. This approach allows the seller to achieve an all-in rate of return of 10%, 11%, or 12%, which, when combined with the tax benefits and preservation of the company’s culture, becomes a compelling reason for many business owners to consider ESOPs.
By having this enhanced return and considering the tax advantages, some business owners are willing to wait for their money, especially if they plan to retire using the ESOP proceeds. They find the prospect of retiring with a steady, attractive rate of return more appealing than receiving a lump sum today and having to invest it in the stock market or other ventures where the returns may not be as favorable.
Ability to Reward Key Leaders
Lastly, ESOPs offer the advantage of rewarding key leaders in a way that may be somewhat disproportionate to the broader employee base. Typically, ESOP benefit levels are distributed pro-rata or pari-passu as a percentage of payroll. However, some businesses recognize that certain individuals, such as the senior leadership team, significantly drive the company’s value. To address this, a synthetic equity pool is created, also known as phantom stock, stock appreciation rights, or a management incentive program. These alternatives serve the same purpose – providing a smaller subset of employees, such as the senior leadership team, with the opportunity to receive an additional benefit that tracks the growth and value of the company’s stock.
When combined with the other benefits of an ESOP, this approach can be highly advantageous. For instance, many business owners initially plan to sell their company to specific individuals who lack the necessary capital to finance the transaction. In such cases, selling to an ESOP becomes a favorable option. The business owner can fulfill their promises to these key individuals by granting them enhanced benefits, while also ensuring their long-term commitment to driving the company’s growth and value on behalf of all the other shareholders, i.e., the employees. This approach proves to be a highly effective way to maintain and enhance the company’s leadership team while empowering the ESOP to flourish.
Drawbacks to an ESOP
Regarding drawbacks or hurdles of ESOPs, some challenges have emerged over the years that may cause individuals to pause and carefully consider their options.
Lower Cash at Close
One consideration is that the cash received at closing in an ESOP transaction is generally lower than what would be obtained in a third-party sale, especially when selling to a private equity fund. Private equity transactions typically yield a substantial amount of cash at closing, while ESOP transactions are structured as cash flow deals, which involve high leverage and require cash flow to service the debt.
For certain companies, such as well-recognized consumer brands or early-stage technology companies, the strategic premium available in the marketplace may not be fully attainable in an ESOP transaction due to its cash flow nature. However, it’s important to note that ESOPs can still pay full fair market value and many deals have demonstrated competitive multiples and valuations on par with other market options. When the valuation offered by an ESOP is combined with the significant tax benefits it provides, the after-tax results for the selling shareholder often prove to be at or even above those achieved through a third-party sale.
Complicated
ESOPs can be perceived as too complex for some due to various factors like floating rate notes, 1042 strategy, regulatory oversight, and the involvement of a trustee. However, with proper education and a competent team of advisors, the process becomes manageable. Certain concerns, such as allocation rules and payroll considerations, may limit flexibility with how benefits are allocated, but solutions can be found to address them and ease the process.
Cost of Administration
There are ongoing administrative expenses associated with ESOPs. A third-party valuation firm is needed each year to assess the stock’s value. A third-party administrator is necessary for stock allocation and participant statements. For companies with over 100 participants, a plan audit is required. An independent trustee, often a paid fiduciary, is also needed, especially for sizable transactions. While annual maintenance costs may be a bit significant for smaller deals, they are generally manageable for larger transactions and not a major concern.
Fiduciary Risk
Business owners sometimes hesitate to adopt ESOPs due to Department of Labor scrutiny and perceived fiduciary risks. They may have heard negative views about ESOPs from others claiming that the Department of Labor disapproves of them. While there is some truth to these concerns, they are generally manageable and should not be considered deal breakers, especially after gaining a better understanding of the situation.
Leverage
Leverage and the need for flexibility can be legitimate concerns that deter some from choosing an ESOP. With proper structuring and seller financing terms, along with a business owner’s willingness to act as a friendly lender, flexibility can be achieved. Nevertheless, it’s essential to acknowledge that in times of company challenges, downturns, or cash flow strain, it can create a leverage situation that requires careful monitoring and management.
Employee Engagement
To maximize employee engagement and reap the benefits of an ESOP, business owners must invest in connecting their employees to the ESOP benefits. It’s essential to recognize that employees may not inherently share the same mindset as the business owner and some may not fully understand the ESOP’s significance. Achieving this level of engagement and ownership mentality demands investment in the softer aspects, such as education and communication, to ensure employees fully grasp the value and potential of the ESOP.
Leadership Succession Plan
An ESOP serves as an exit strategy, an ownership transition strategy, or an ownership succession plan, but it is not a replacement for leadership succession. If you plan to sell to an ESOP, it’s crucial to understand that you cannot simply walk out the door unless you have a strong team capable of maintaining your legacy and driving further growth. If your leadership team is not robust, it is advisable to strengthen it before considering an ESOP as a viable option.
Fiduciary Obligations
Let’s delve into the fiduciary aspect of ESOPs. As a qualified retirement plan, an ESOP must hold its assets in a trust controlled by a trustee. The company chooses who will serve as trustee and the trustee, acting as the buyer of the stock on behalf of the employees, holds the role of the shareholder of record. Under ERISA, the trustee must act on behalf of the participants and in their interest. Although some individuals may fear losing control with a trustee in place, the trustee’s primary objective is to maintain the existing board, president, and leadership team. Their aim is to see the company thrive and grow while overseeing the trust’s assets. They generally do not intervene significantly in the company’s day-to-day operations or strategic decisions. While they attend board meetings and provide counsel when sought, their level of influence is typically limited.
Advisors
It is crucial to have the right team of advisors on board to ensure a successful ESOP journey and help navigate the complexities and nuances associated with ESOP transactions. For business owners, a sell-side advisor acts as their representative in the transaction, offering expertise in M&A and corporate law. Another essential advisor is the ERISA expert, responsible for ensuring compliance with ESOP-related plan documents and regulations.
The trustee is a vital player, typically an independent fiduciary, hired by the business owner to oversee the ESOP. The trustee, in turn, hires their own financial advisor and legal counsel to form the buy-side team. This is the minimum level of involvement of advisors. Larger transactions may involve separate legal counsel for individual selling shareholders.
Most transactions work better when the selling shareholder has a sell-side advisor other than their legal counsel to help them model the transaction and provide valuation, structuring advice, and deal terms to guide the business owner through the process.
For those looking to defer or avoid taxes through the 1042 route, additional advisors, such as senior lenders, wealth advisors, tax advisors, and 1042 specialists, may come into play. Companies with over 100 participants will need a plan auditor.
Financing
To summarize the financing and transaction structure of an ESOP, it begins with the formation of the ESOP, which can be funded through contributions, loans, or stock from the company. In a classic ESOP transaction, the company borrows money from the bank and loans it to the ESOP. The ESOP then purchases the stock from the selling shareholder.
A note swap is executed, creating two notes – one between the company and the seller and another between the company and the ESOP. The note between the company and the seller is important for cash flow. This note is generally subordinated to the bank loan and spans 8 to 10 years with warrants included to ensure a higher return for the seller, corresponding to the risk taken. The note between the company and the ESOP is a long-term note between 30 and 50 years at a low interest rate.
During the repayment period, the bank loan is gradually repaid and the seller receives interest-only payments. Upon the seller note’s maturity or early repayment, warrants are exercised, providing the seller with another lump sum payment. Contributions to the ESOP release shares to employees’ accounts, allowing them to accumulate their benefits. When employees leave the company, the ESOP buys back their shares at the current fair market value and these purchases are typically spread over five or six years to manage the cash flow impact on the company. The essence of the ESOP lies in employees building their pool of wealth through this process.
ESOPs as an Exit Strategy for Business Owners
There are two primary exceptions that make ESOPs work really well as an exit strategy for business owners. The first one is that ESOPs are exempt from diversification rules, which means they are designed to invest in company stock and one company at that – the sponsor company. The second exception that makes ESOPs different is they are the only ERISA plan where the plan itself can borrow money to facilitate the purchase. In an ESOP, you have a situation where a business owner can sell to a trust for the benefit of their employees and get many benefits as described above, including significant tax benefits, preservation of culture, less intrusion in terms of the sale process, and a number of others. At the end of the day, an ESOP is a buyer that’s created and stands ready to buy company stock at full fair market value.
An increasing number of companies are recognizing the value of ESOPs. Currently, there are over 6,000 ESOP-owned companies across the United States and many renowned companies have already embraced the ESOP model. ESOPs prove to be a highly viable and effective strategy, especially in specific cases. If you are interested in an ESOP for your organization, contact us and we can explore this model with you to see if it is a fit.