12 May Pros and Cons of the ESOP
Benefits to Business Owners Selling by ESOP
- Flexibility: Equity holders (sellers) can sell any portion of their ownership to the ESOP and simultaneously sell or gift any portion of their ownership to any other party in any manner or arrangement they choose – at any time they choose.
- It’s a stock sale! Sale by ESOP is always a stock sale and often provides substantial legal and tax advantages to the seller.
- Zero tax? C-corporation sellers can defer 100%* of their tax bill by rolling sale proceeds into qualifying publicly traded securities. If your company is incorporated in a state that has NOT adopted the federal ESOP law, you may not be able to defer state capital gain taxes.
- What’s good for the goose. After the ESOP sale takes place, your business can expense (i.e., deduct from income taxes) payments to the ESOP (they’re retirement plan contributions). The ESOP trust does not have to pay taxes on the receipts (it’s a non-taxable entity), nor do the employees (they own shares within a retirement account, which is tax-deferred). In this way, ESOP/employee-owned corporations can avoid federal income taxes (and in many states, state income tax) to the extent that the business is owned through the ESOP. In other words, if 70 percent of the business is owned by the ESOP, 70% of corporate income is not taxed. In this way, cash flow is improved and buyout debt can be amortized sooner.
- A job – If you want it. As the seller, you can remain active in the business and retain operating control even after selling all or most of your company.
Drawbacks to Business Owners Selling by ESOP
- Seller Financing: Owners who sell by ESOP rarely can get full cash payment at closing. More often, the seller must accept payments over a number of years from the cash flow of the business. The seller may have to continue to bear some financial risk for years if the business falters. In addition, if leverage is used to buy out the seller, lenders may require the seller to personally guarantee the loan for a specified period of time. Finally, sale proceeds tied up in a seller finance note are not available to purchase “qualifying securities” and thereby receive tax deferral.
Mitigant: Most business sales include seller financing. In fact, studies show that 70 percent of private company sales contain some portion of seller financing, most commonly 50 percent of the sale (see Transaction Patterns by Toby Tatum).
- Seller may “leave some money on the table”: If you don’t offer the business to all potential buyers, then you may never know whether you could have sold it for a better price.
Mitigant: You can always offer the company globally and have an ESOP appraiser value the business, then choose the route that offers you the most attractive terms. But this is often hard to do because the process of finding potential business buyers can be very inefficient. There is no way to determine in advance everyone who might be interested in buying your company. Even with a well-planned and proactive campaign, buyer candidates tend to “trickle in over time.” Furthermore, over time, even in mere months, motivations, strategies and markets can change your desire or ability to pay off particular buyers. The result is that you are always left wondering if you’d waited a little longer or searched a little more, you could have found a better deal.
Benefits of the ESOP to Companies Owned in This Manner:
- Stability: Companies purchased by employees by ESOP are far more likely to remain intact and operate as independent entities (as opposed to being bought, sold, merged, relocated or liquidated).
- Improved Employee Relations: ESOP-owned companies have fewer incidents of employee litigation, fewer workers’ compensation claims, lower turnover and a heightened ability to recruit and retain talent.
- Lower Borrowing Costs: ESOP may add financial flexibility and/or provide a way to lower your cost of borrowing. The ESOP can borrow money and use the funds to buy additional ownership (shares) from the company. The ESOP enjoys tax-free status and, therefore, a lower borrowing cost. The company gets the funds.
Drawback of the ESOP to Companies Owned in This Manner:
- Cash flow obligations, take 1: The ESOP is basically a leveraged buyout. It is a mechanism whereby the company buys itself from the owner and then, over time, distributes purchased shares to its employees (at no cost to them). It binds the company to cash flow-sapping buyout payments and adds financial risk.
- Cash flow obligations, take 2: Setup costs can be substantial – estimated at 3-6 percent of the total purchase price. In addition, regular appraisals are required to value the shares of stock, and management of the ESOP requires ongoing administration, reporting, etc.
- Cash flow obligations, take 3: The ESOP is a defined contribution retirement plan and, as such, is obligated to buy back the stock of departing employees. If many of the employees are near retirement age, this could create a cash burden on the company/ESOP.
Benefits to Employees of an ESOP-Owned Company:
- American Dream: Employees receive ownership in the business over time for free (or as a part of an overall compensation package).
- Liquidity: Employees have a ready market for their shares if and when they depart, as long as the company has sufficient liquidity.
- Security: ESOP-owned companies highly value the interests of the employees, whereas traditional owners by nature consider their own interests first, which could lead to a sellout and liquidation. Research shows that employees of ESOP-owned companies enjoy higher pay, better benefits and twice the retirement benefits of their counterparts.
Drawbacks to Employees of an ESOP-Owned Company:
- Discrimination: If the seller takes advantage of the capital gains tax deferral option, family members of the seller and 25% of the stockholders must be excluded from the ESOP.
Mitigants: With today’s low federal income tax rates, many sellers are not taking advantage of the tax deferral option. If the seller wants a family member(s) to own a block of stock in the company, the seller may gift or sell any amount he or she desires before or after (assuming the seller retains some of his or her shares) initiation of the ESOP. 25 percent of owners who want to participate in the ESOP as employees can sell shares prior to formation of the ESOP, or sell to the ESOP at inception, to lower their stake below the 25 percent threshold.
Ms. Carol Mayo Cochran of REDW Business and Financial Resources, LLC (www.REDW.com) contributed her considerable expertise for this article.
There are more than 10,000 ESOPs in the U.S., covering 8 million employees.
Source: The ESOP Association