How Do I Sell a Business? Consider an ESOP

It can be hard for a private business owner to find the best way to exit, and rightfully so. There are pros and cons to any exit, so they have to think hard about what they value most: a quick exit, a high value exit, or an exit to preserve their legacy. If you’re lucky, you can do all three, but most often there’s a give and take between them. One exit option to consider for those who want to keep the business “in the family” while preserving their legacy is an Employee Stock Ownership Plan.

What is an Employee Stock Ownership Plan (ESOP)?

An ESOP is a defined contribution plan; this means that it is a qualified retirement plan, as the IRS defines it, in which each year the company contributes stock, much like a trust, for the benefit of the employees. Once an employee leaves the company, they get a distribution based on the market value of their shares.

The appraised market value of these shares is competitive and can be enough to prevent a buyout from a private equity firm. Thus, an ESOP is effective in selling your business to your employees while maintaining the legacy you’ve built up over the years.

How much control does the seller give up?

The seller actually has a lot of control in how to set up the ESOP and how to transition out of the company.

First of all, they decide on how much to contribute to the plan and how much cash to receive. So, an ESOP can be a minority shareholder, a majority shareholder, or it can own the whole company. If the seller prefers to receive all of the cash up front, then he can set up a leveraged ESOP. In such case, the employees will gradually receive ownership from the lenders.

Because this type of exit creates a gradual transition, it affords the seller time to train the succeeding management team while also receiving upfront liquidity. An ESOP can also be coupled with a Management Incentive Plan to reward and retain key management. Plus, the seller can choose to remain active in the business and retain operating control, even after selling all or most of the company.

Why an ESOP?

ESOPs are used to create liquidity from a private business. A major benefit for the sell is the ability to exit even if it isn’t a seller’s market.

The amount of stock an ESOP owns is exempt from federal and most state income taxes. In addition, the tax shield it creates offers an increase in cash flows which can then be used to pay off the leverage that helped create the ESOP, invest in PP&E, or expand the business.

All contributions are tax-deductible and employees receive equity without paying current income taxes or investing any capital of their own. Also, when eventually cashed out, the accounts can then be rolled over tax free to an IRA.

Above all, when employees participate in this plan they share an interest in creating wealth for the shareholders and therefore focus on company performance.

What makes a good ESOP candidate?

If any value is to be created for the employees who are to receive ownership in the company, then consistent profits are necessary in order for the contribution plan to be incentivizing. Also, consistent cash flows are needed in order to pay off any leverage used to create the ESOP, as previously mentioned.

Assure that not all employees are expected to retire at the same time, as such could create a significant cash burden on the company.

Lastly, make sure that a good management team is in place, since the seller is giving up ownership to the employees. Fortunately, most ESOPs are very effective in lowering the turnover rate, as well as in recruiting and retaining talent. A good management team will allow the seller to not only make a peaceful exit but also to preserve their legacy in the long run.

Andrew Dunnington
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