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ESOPs: It’s not always about the money

By Steve Eide

What motivates a business owner to sell to employees?

“It just didn’t feel right.”

That’s what one ad agency owner said after entertaining merger offers from several competitors. He pushed back against the trend toward consolidation in his industry because, “You potentially hurt some of those things [that you worked to create]. You lose jobs, you hurt culture, you lose clients.”

Similar concerns were expressed by the owner of an electrical contractor.

"It's significantly easier to sell to an outside party because they hand you a check all at once and you turn over the business to them," the owner said. "But I didn't want to take the people who had built this business and hang them out to dry. You are either a family and a team or you are not."

In these two cases, the employees became equity stakeholders, but not by buying the company directly from the owners. Instead, the owners found the solution to their concerns in an employee stock ownership plan, or ESOP. An ESOP is an employer-funded retirement program created to hold the company’s stock in trust on behalf of employees.   

The ESOP conversation often focuses on the tax benefits, such as the selling owner’s opportunity to defer or avoid capital gains taxes under IRC Section 1042 or the extraordinary tax advantages for the ESOP-owned business after the transaction. But that’s not the whole story. There are also many ways in which an ESOP can meet the nonfinancial goals of a business owner.

Alignment with personal values

For many owners, the right time to sell the business coincides with what psychologist Erik Erikson identified as the eighth stage of psychosocial development, beginning around age 65. It’s a time when one reflects on whether they have lived a successful life in harmony with their moral values and life’s purpose. For owners with that mindset, an ESOP may be the ideal exclamation point at the end of a fruitful business career. Benefits of an ESOP:
  • An ESOP anchors the company to the community, avoiding the risk that a buyer will dismantle or relocate it.
  • Jobs are retained when a company becomes employee-owned, whereas merging with a competitor usually results in the elimination of positions that have become redundant. In fact, research shows that ESOP companies not only retain jobs, but they create new jobs faster than their non-employee-owned counterparts.
  • ESOPs give employees a chance to build savings, funded by employer contributions, and to feel like they are “part of something.” It’s a tangible way for an owner to show gratitude and reward the employees who helped grow the business.
  • Selling to employees virtually assures that the current management team will remain in place and guarantees opportunities for career advancement as the owners transition out of their roles running the business.
  • Business owners with concerns about the vanishing middle class have embraced ESOPs and wide-based equity ownership as a strategy with potential social benefits above and beyond the significant financial benefits received by employees on an individual level.

Flexibility

Strategic buyers and private equity firms are likely to have a rigid timetable for acquiring all of a target’s stock or assets, and for completing the transition to new leadership. In contrast, ESOP purchases can be structured precisely to match the owner’s ideal exit strategy.

Some ESOP deals transfer 100% of the stock to employees in a single transaction with the owner riding off into the sunset. Other times, the ESOP acquires shares in stages over any number of years, allowing owners to diversify a portion of their investment in the company before they fully disengage from owning and operating the business. In either case, the ESOP trustee and the company’s board of directors will often wish to retain the owner’s services after the sale if he or she is interested in remaining involved.

Desirable transaction structure

When given their druthers, most sellers prefer to sell stock (as opposed to assets). As a rule, ESOPs always purchase stock. 

Selling shareholders also tend to like the certainty of a fixed price without an earn-out. ESOPs like the same thing. To comply with fiduciary requirements, ESOP trustees need assurance that the total purchase price does not exceed the fair market value of the stock on the closing date.  Unless the earn-out is capped at a level unlikely to be acceptable to a seller, a fixed price is the only way to satisfy both sides.   

Preservation of legacy

Although business owners who opt for employee ownership frequently talk about personal values, flexibility or transaction structure when explaining their decision, the motivator that probably gets the most mentions is “preserving our legacy.” The importance of keeping the company intact and independent is certainly understandable after spending years to build the enterprise, and perhaps multiple generations of devotion in the case of a family-owned business.

The legacy they want to protect may be the business entity itself: its name, its identity, its place in the community. All of this may be lost if a third-party buyer guts the business and sells it off in parts or, alternatively, causes it to be absorbed into another company or division. An ESOP not only preserves the company’s separate existence, but it provides financial, tax, cultural, motivational and recruiting/retention benefits that make the business more resilient and sustainable into the future.

But the legacy often involves more than the corporate entity and infrastructure. We see many instances where a company was founded and developed with a broader purpose — to be a values-driven enterprise that exists to generate more than profits.

Gary Erickson, a cofounder of Clif Bar & Company, draws a connection between the company’s decision to form an ESOP and their desire to remain free to pursue a five-bottom-line business model — the Five Aspirations — focused on sustaining their business, brands, people, community and the planet. By transferring ownership to employees who already embrace the company’s values, Erickson knows he can preserve the unique culture he has worked nearly 30 years to create.

Consider this alternative

Is there an ideal buyer for a privately held company? Maybe not. But owners can take comfort in knowing there is an excellent alterative for them and their employees if a third-party sale just doesn’t feel right.

The Minnesota Center for Employee Ownership serves as a free unbiased source for education and resources around all forms of employee ownership. With 52,000 business owners older than the age of 55 in Minnesota exiting their business in the next five years, there is a crisis looming. What will happen to their legacy, employees, community?  Business owners will look to their advisers on how best to exit.  Contact us for more information on how we can be a resource for you at www.mnceo.org or reach Sue Crockett, MNCEO executive director at scrockett@mnceo.org.

This article was written by Steve Eide, whose practice focuses on ESOPs and other employee benefits at Saul Ewing Arnstein & Lehr LLP, a full-service law firm with an office in Minneapolis. You may reach him at steve.eide@saul.com.