Episode 3 of What’s Next Hosted by Acuity Advisors
In this episode, Chris Kramer and Chase Hoover talk about a flexible, tax-advantaged alternative exit strategy for business owners who are ready to make that long-awaited transition. It’s a plan that can preserve or even enhance corporate culture, provide a meaningful employee benefit, and ensure the legacy and sustainability of the company over the long term. It’s the Employee Stock Ownership Plan.
Chase: Hello, and welcome back to What’s Next, hosted by Acuity Advisors. The show where we help middle market business owners understand and monetize the value of what they built. I’m your host, Chase Hoover and I’m back here with my co-host, Chris Kramer, to talk today about a flexible, tax-friendly, alternative exit strategy for business owners who are looking to make that transition. Welcome back, Chris.
Chris: Well, good morning, Chase, thank you. What we’re talking about today is what’s known as an Employee Stock Ownership Plan or an ESOP. And the great thing about an ESOP is that it’s a flexible tool to have a business owner exit the business. It can preserve and enhance corporate culture. It can provide a meaningful retirement benefit to an employee base. And I think maybe best of all, operationally and from a day-to-day perspective, nothing really changes after the transaction closes. So from that perspective, it’s a great alternative to a third party sale. And we’re going to explore a couple of aspects of it today, primarily the benefits and how it works, and in a future podcast, we’ll be talking about more of the mechanical aspects and kind of drilling down on how they actually get implemented.
Chase: Got it. So first things first, we’re talking about an ESOP as a potential exit strategy or alternative to, let’s say, a sale to a private equity buyer, or maybe a company in the business owners’ industry. So if I’m a business owner and I’m hearing about ESOPs and all the tax benefits and cultural benefits, why do I initially choose to explore one? What are some of the more attractive characteristics of an ESOP to me, as the seller?
Chris: Well, from a tax perspective, it’s effectively the only way that a seller can sell their business and actually avoid, not just defer, but actually avoid paying the capital gain tax on the sale of the business. And that’s a huge advantage where the capital gain tax currently is 20% federal. In California, where we live, there is no capital gains rate, so you’ve got a 9% state income tax. And so to be able to avoid the tax altogether is a giant benefit. There are some benefits to the company as well. From a tax perspective, it’s primarily the ability to deduct the contributions that get used to repay the debt. So in other words, the transaction is financed with pre-tax dollars. And then from the employee perspective, they get to defer the benefits, not unlike other retirement plans, until they’re ready to retire or achieve retirement age. So tax wise, there are benefits really all around if structured correctly.
Chase: Right. And on top of that, from the seller’s perspective, the question of whether or not you’re comparing an ESOP as a strategy to, let’s say, a third party sale assumes that the business is actually of interest to a third-party buyer. I think in a lot of situations an ESOP can provide an ability for that owner to begin exiting or just exit the business where under other circumstances, they may not actually be able to affect a sale for whatever reason. So I think there’s that component to it as well.
And then from a tertiary perspective, you already alluded to this, that ESOP transactions are generally leveraged, meaning there’s debt involved. And we’ll get into that in more detail in this follow-up podcast you’re talking about because there is that financing involved. Oftentimes, you as the seller are going to be financing a portion of the deal. And you can get a pretty favorable rate of return out there in an otherwise really low interest rate environment for the financing that you’re willing to provide, for a risk that you’re basically already taking by owning the business. You’re sort of still the master of your own fate after the deal if you choose to be.
Chris: We talked a little bit also about flexibility. And really what we mean there is not only in terms of how the transaction is structured … pre-tax dollars … whether the seller wants to take advantage of this avoidance or deferral … how the seller financing is structured, but really just the ability to sell less than 100%. Ultimately, trying to get to a 100% is generally the goal, but we’ve done ESOPs at a few percent. We’ve done ESOPs where the company makes a stock contribution and gets a tax deduction and there’s not an actual transaction with the seller on the first traunch or two. We’ve done deals at 50%, 51%, or all the way to 100%. So where they work really well, as you’ll hear later, is when you have multiple shareholders with different objectives, there’s a lot of other fact patterns that line up really well. But when we talk about flexibility, there’s flexibility in terms of structure, in terms of the amount sold, in terms of timing of various aspects of the transaction and, again, a host of others.
Chase: Right. And I just want to expand on that a little bit for potential listeners who are really new to the ESOP. The reason that this structure affords so much flexibility is because, in essence, what we do when we implement an ESOP and that ESOP buys shares is, we’re basically creating the buyer. We’ll get into the mechanics, again, down the road. But unlike a third-party buyer who comes to the table with their own investment objectives or investment criteria or certain things that they just will or won’t agree to in a deal that can then create conflicts with your goals and objectives, the ESOP doesn’t have preconceived goals. It just has certain limitations.
So as long as you structure the deal to live within, it’s generally deemed to be a reasonable structure, whether that’s valuation, like I said, structure, benefits, governance, whatever the term or the item may be, the buyer is… I don’t want to say indifferent … but it’s open, it’s flexible. Because it doesn’t have other human beings on the other side of the table who run a private equity firm or already operate a business and want certain things out of the deal that may not be favorable to you.
Chris: And one of the reasons that’s true is because the buyer is passive. It’s actually a trust that’s formed for the benefit of the employees. And so that means it doesn’t try to run your business. It doesn’t try to tell you what to do as the seller or as the CEO. It’s really trying to make sure that whatever the promise was, in terms of the expected retirement benefits, ultimately get delivered to the employees. And that’s a function really of the growth in the company and ongoing performance. The other interesting aspect about an ESOP is we see them oftentimes used as retention tools and as recruiting tools, because it’s really the only way that most people, especially those that don’t own other assets, and even if they do, the only way that they can actually influence the value of the investment and how that happens, obviously, is people come to work every day.
And so to the extent that employees are highly motivated and performing at a high level, chances are pretty good the company is going to perform at a high level. Companies that perform at high levels are worth more and grow and become very valuable. So back to the flexibility, we often see business owners a little bit tentative about selling 100% of their company to an ESOP. They don’t know enough about it. They don’t really understand how it’s going to work. They want to kind of test drive how it might work, and yet they’re excited about the tax benefits, they are excited about potentially providing a benefit to the employees, and probably most importantly, oftentimes they’re excited about preserving culture while still implementing an exit plan.
And what works really well is selling less than 100% to the ESOP, having the benefits start entering to the employees, such that they’re getting excited and motivated and start really adopting an ownership mindset, if you will, the company ramps up and then sells to a third party, 3, 5, 7, 10 years down the line. So there are, again, a lot of sort of options to how to make this a really effective tool.
Chase: And you alluded to something there that I think is really important when you talk about good candidates for an ESOP transaction, and that’s a focus on culture. So we’ll just take a step back and answer may be a bigger question. Who does make a good candidate for an ESOP transaction, in terms of a business? Because we’re talking about all the positives in an ESOP, and there are certainly quite a few, but it’s not for everybody.
And so one of the primary things that I’d highlight as a draw to an ESOP in lieu of another transaction structure is the ability to not only preserve, but enhance, and really underscore culture by implementing an ESOP. It’s not going to imbue a culture where there wasn’t one previously, but if there’s a team in place and a culture in place that the group is proud of and doesn’t want to see altered or even put at risk by new ownership or big change in strategy from a corporate parent, an ESOP is the perfect way to make sure that not only is the existing culture preserved and promoted, it’s solidified. Because now, not only do you have dedicated employees, you have dedicated employee-owners.
Chris: Not only solidified but enhanced. Because now, you’ve got a mechanism for all of the sort of promises, for lack of a better word, to actually materialize. And a lot of that is in the hands of the employees themselves. So we see a lot of service businesses with highly educated workforces, consulting firms, architects, engineers, environmental consultants, those types of firms tend to, not only make good candidates, but I think more importantly, end up being great ESOPs. Because the corporate culture generally already exists such that the things we’re describing here actually take hold and manifest themselves into future performance growth, increased in value, et cetera. Mechanically, companies just overall with higher payrolls tend to make better candidates relative to value. So in other words, highly capital intensive businesses with low payroll, they’re a little harder to structure, can still be done, but payroll is an important consideration in the structuring, which we’ll get into in the next podcast.
But to the extent that you have relatively high payroll, good, better candidates, if you will, I mentioned the multiple shareholder situations. Companies, I would say, that maybe don’t have a high degree of a strategic premium out in the market, because even though you get great tax advantage to doing an ESOP, and even though you can get a great rate of return on the dollars, you don’t get much money at closing and that is cause for concern for a lot of business owners. When private equity is out there waving pretty big multiples for strategic companies and most of that money ends up being paid out at closing, the tax benefits to an ESOP can sometimes be kind of secondary to wanting to cash out. And lastly, I would say, again, mechanically, and for reasons we’ll talk about in our next podcast, companies that are right now and currently C corporations are really great ESOP candidates.
And in fact, if you are sitting as a business owner thinking about selling and you’re an existing C corporation, you almost have to look at an ESOP as an alternative, at least to understand what the impacts are. And the primary reason is because if you end up selling the assets of the company, or if the buyer will buy your stock but wants to make an election under the tax code that treats it as an asset sale, you may be materially worse off in this scenario as a C corporation. That will be materially worse off as a C corporation in most cases than as an S corporation. But it turns out, that sets up really well for an ESOP, because one of the requirements to take advantage of this tax avoidance is to actually be a C corporation. Without getting into the weeds, we’ll talk about it next time, if you’re not a C corporation, it’s okay, we can actually revoke the S election. But if you’re an existing C corporation, it works really, really well.
Chase: Absolutely. So on the other hand, just for purposes of this kind of introductory summary discussion, we’ve talked a lot about who makes a great ESOP candidate, but there is no perfect solution. So I want to sort of explore some of the drawbacks mainly, and you’ve actually already alluded to a couple of them. Really the primary ones are there may be some component of strategic value that you’re leaving on the table by virtue of not selling to someone in your industry who wants to pay a handsome multiple. I think, candidly, the types of businesses that orient themselves more towards ESOPs generally don’t have that type of strategic multiple or strategic value that they command in the market, whether it’s because they’re a contractor or subcontractor that doesn’t have much in the way of recurring revenue, things are non-recurring, there boom and bust or cyclical, whatever the reason may be.
But I think the other big one is the other thing you alluded to, which is that you’ve got to be willing to wait for a lot of the money. If you’re looking to sell a controlling interest or 100%, which is when these tax incentives really start to materialize and become more robust, then because of the fact that the company has got to pay off the transaction debt, you’re not just walking away, day one, with all the transaction proceeds. You’ve got to be willing to stick around it. And like we said, there are benefits to that. You get a pretty meaningful rate of return on any portion of the deal you finance. But for business owners whose core, sole objective is to get a deal done and walk away or ride off into the sunset, ESOPs can be a little bit more of a high hurdle.
Chris: And they are very much an exit strategy. While there’s a succession strategy component to it, the leadership of the company still has to be in existence after you, as the seller, are going to be sort of ready to retire. So even though you might have transitioned the ownership, if you don’t have great management or leadership beside or beneath you, or someone ready to take the reins, it’s a little harder to make them successful, as opposed to selling to a third party that’s already got a management team or leadership teed up. And if your goal is to really exit the operations relatively quickly then perhaps an ESOP won’t make quite as much sense. But certainly, every situation is different.
One of the other drawbacks is the kind of government oversight. I mean, it is an ERISA plan meeting. It is governed by the Department of Labor and pension laws, similar to what governs a 401k, in some but that is been cited by a number of our clients is kind of an ongoing drawback.
Chase: Right. There are certainly costs involved. I would say, though, that relative to a sale to a third party, if, as the business owner, you were represented by an investment banker or just another advisor, or, let’s say, fairly robust legal counsel, ESOP transaction costs, generally speaking, it’s not always the case, but generally speaking, represent less relative to the overall transaction value than they likely would in a third party sale. So it’s not free, it’s not dirt cheap, but it’s not the most expensive path, either.
Chris: Certainly on an implementation basis, I fully agree with that. So in closing, I guess what I would say about ESOPSs, there are about 7,000 of them in the country, plus or minus. They’ve been around since 1974, so this isn’t a new thing or a black box or anything like that. Lots of companies have been successful ESOPs and then sold to third parties, so it doesn’t preclude you as a business owner from that strategy. There are pretty good statistics that show and demonstrate that ESOP companies tend to outperform their industry peers. They tend to weather downturns better. They tend to be slower to lay off people because the people are valuable. And generally speaking, they tend to work out pretty well in most cases.
That said, they’re complicated. There are lots of moving parts that have to be cared to and fed over time. There are maintenance costs. There is a communication aspect, in terms of getting the maximum benefit out of employee performance that you sort of have to be mindful of. And they’re certainly not for everybody, but for candidates and business owners that think that they’re viable, you certainly want to get good advisors and we’re here at Acuity to help you decide if it might be right for you.
Chase: Absolutely. Well, thanks, Chris. I think this was a helpful starter kit on ESOPs. And tune back in next time, everyone, if you’re still hanging with us in the late stages of this podcast, for a little bit more of a deep dive on some of the mechanics, how to make an ESOP really maximally favorable from a tax perspective, as well as structuring components and layering in retention tools for key people. We’re going to get into all that. So until then, thanks for listening.
Chase: Quick fine print. This podcast is for general information purposes only. It does not create an advisor client relationship between Acuity Advisors and the listener or reader, and is not intended as advice for a specific situation. And as always, we’d like to thank our sponsor Acuity Advisors. Until next time, take care, everybody.