Evaluating whether an ESOP is appropriate when it’s time to sell the business…
In ESOPs: The Three Types, we explain the three basic ways an Employee Stock Ownership Plan (ESOP) can be used to effectively motivate employees to increase productivity and company value. In this article, we will discuss one of those uses, the ESOP, and its benefits as part of succession planning for a closely held corporation.
Because most non-publicly traded corporations eventually face the challenge of succession planning, the only big questions for the owner or owners are how and when: transfer ownership to a family member, sell to a third party, merge … or fold the tent and go home.
Those business owners who don’t plan on family succession usually assume that when they’re ready to retire/sell/move on, there will be a buyer waiting in the wings with ready capital. But in the real world there aren’t many buyers that will meet a seller’s initial expectations. And even if a ready buyer is found, one of life’s two certainties will still probably dampens the owner’s expectations for the long awaited payoff, taxes.
An ESOP is the sometimes overlooked alternative to the above-described scenarios. It assures a ready buyer (the corporation’s own employees), and was designed by Congress to encourage owners to sell stock to ESOPs by allowing the seller to defer federal capital gains tax. Sometimes the government does want you to be happy.
This article looks at some pros and cons of the various succession planning alternatives as compared to an ESOP.
Assemble And Review The Alternatives
The owner’s business advisors should bring to the table all viable succession solutions, including family limited partnerships, sales to third parties, a non-ESOP sale to management, an ESOP, or simply the liquidation of the company. He or she should be advised of the tax, control and estate planning concerns and economics of each alternative for him or herself and the family, and how they affect the company and its employees.
Because ESOP’s versatility can lend itself to complexity, some business advisers may not bring it up because it seems to compete with other traditional alternatives with which they’re more comfortable and familiar. It is important when assembling all the alternatives to ensure that the ESOP is included and seen for what it is and what it can do. Those advisors who are inexperienced with ESOPs should include an employee benefits attorney or specialized ESOP consulting firm to help evaluate the alternative.
Understand How An ESOP Fits Into The Planning Process
As a part of the succession-planning process, the ESOP can:
- Allow the selling shareholder to reinvest the proceeds of the sale of stock without immediately paying federal capital gains tax.
- Lower the costs and facilitate cash flow in a management-led purchase of the company.
- Provide a market for stock where otherwise no market existed.
- Be used to acquire shares with pretax cash flow.
- Be used to retire or buy out a dissident or unhappy shareholder.
- Help provide estate liquidity for heirs that wish to continue in the family business.
- Be used to help establish minority discounts on family-held stock for estate planning purposes.
- Help attract financing at about 85 percent of the cost of conventional financing.
- Be a minority purchaser of stock, providing asset diversification, or a 100 percent purchaser of the company.
- Permit the seller to remain involved while the purchase is being completed, thus lowering the seller’s risk.
- Help attract minority-subordinated equity investors in a management-led buyout.
Often, more than one of these ESOP advantages can apply to a business owner’s needs. For example, a sale of shares to an ESOP can provide the selling shareholder with capital gains deferral, finance the purchase with pre-tax dollars, and permit the company to borrow in order to finance the purchase with a loan at an interest rate lower than they could have normally obtained.
Ask The Right Questions
After an initial glimpse at what an ESOP can do, the shareholder needs to carefully evaluate the suitability of the business planning alternatives. There are some basic questions that must be addressed about the company and the shareholder owners to determine whether an ESOP is worth considering, including:
- Is the company a corporation taxed in the normal manner and not a Sub Chapter S corporation?
- Is the company closely held or publicly traded with significant ownership in a few hands?
- Does the company have sales and payroll adequate to support an ESOP, meaning total current and projected payroll as a percentage of sales is perhaps 20 percent or greater?
- Does the company have a strong earnings or cash flow record over the previous five years?
- Does the company expect to pay substantial federal income tax over the next few years?
- Do at least some stockholders have a reason why they might be interested in selling some stock (e.g., planning for retirement, liquidating an estate, entering a new business venture, children not involved in the business, etc.)?
- Will one or more principal executives be departing in connection with the sale, and is there strong management available to take their places?
- Does the company customarily make payments to a profit sharing or other employee benefit plan that could in the interim be used, or in part, to fund an ESOP?
- Are the owners psychologically willing to share ownership with their employees, assuming that an attractive deal can be arranged?
Characteristically, the last of these questions is often times the most difficult question for the business owner to answer. The cash flow and financial questions are objective, quantitative and easy to measure. However, the notion of selling ownership to an employee group or to the employees can be something the owner shareholder has a hard time envisioning, unless next-generation management has already been addressed.
An owner has to consider that there may not that many buyers available to acquire the company. The all-cash buyer is a classic myth of the closely held corporation. More often than not, sale to a third party involves a certain amount of cash up-front, with the remainder of it financed over a period of time. It is sometimes possible for a buyer to obtain cash financing through a bank or other lender, but typically this is not for 100 percent of the purchase price. Sometimes, alternative sale approaches are “earn-outs” or other payments depending upon future profitability of the company that is being sold. Finally, there is also the possibility that a merger could occur with a publicly traded corporation in which the owner of the closely held company receives shares from the publicly held company. In that situation, the seller does not receive cash, but in theory the shares he receives in payment are more liquid and more easily disposed of in the market, although this is often times subject to substantial restrictions after the sale.
So what then does a selling shareholder do? It is important to get objective and expert information and a comparison of the sale alternatives to determine whether the trade-off in the last question, above, can inspire him to consider an ESOP. After all, that is precisely what the Congress intended when they passed all of the tax incentives for ESOPs. They wanted them to become attractive enough for the shareholder owners to consider their employees as not just an attractive alternative, but arguably one of the best alternatives available for selling a closely held business.
Consider These Important ESOP Suitability Questions
Whether an ESOP is suitable for the owner and the company also depends upon a number of factors. While the tax advantages apply to nearly all (assuming a company is profitable, is paying taxes, and can use the tax benefits), other less quantifiable issues have to be weighed, including, for example:
- Is the company in an industry that is labor- or people-intensive and can take advantage of the ESOP’s promise of productivity enhancement?
- Is the company in a highly cyclical industry with extreme ups and downs in stock value?
- Is the company in an industry that has a high risk of obsolescence? That is, could a change in technology put it out of business at any time for reasons beyond its control?
- Does the company have such thin margins and poor cash flow that it can’t afford a financed buyout?
- Does the shareholder have family members he wants to take over the business and control it in a legal and absolute sense?
- Does the company have a second level of management that is ready, willing and able to take over the operation and growth of the company after the buyout?
- Does the company have enough employees and eligible payroll to permit an ESOP to reasonably spread the stock ownership and support the contributions to the plan?
- Would the ESOP be the only retirement plan the company offers, or would a 401(k) or other plan also be available?
- Does the business owner want to sell the company but maintain complete control?
- Does the owner and future management want to use the ESOP strictly as a tax boondoggle, or are they really interested in sharing ownership with other employees?
The answers to these questions may contain a few that indicate that an ESOP may not be suitable for a company. However, there are few obstacles that may be identified in this list that are intrinsic to ESOPs. That is, most of the reasons an ESOP is not suitable are company-specific, owner-specific, or economic and financial. In most situations, it is not the ESOP itself that is unsuitable for a given company. In the course of analyzing the trade-offs and advantages of an ESOP, certain common myths and misconceptions will rise to the surface. Do any of these sound familiar to you if you are a business adviser or business owner? Have you heard these before? While complete and exhaustive answers to those misconceptions are beyond the scope of this article, hopefully we have begun to address them.
What To Do?
For the owner interested in selling, it is important to be sure that all business planning alternatives are considered. Before you choose an ESOP, though, be sure to have a qualified employee benefits attorney or consultant evaluate all the positives and negatives that will determine whether an ESOP can bring a happily-ever-after conclusion to your business planning needs.