Help  |  Pay an Invoice  |  My Account  |  CPE Log  |  Log in

Is an ESOP the right exit strategy for you?

By Patrick Schmidt, Value Consulting Group

October 15, 2021

In the next two decades, it is likely that a large number of the estimated 12 million privately-held businesses in the United States will change hands, driven in large part by the exit of baby boomer owners. While many of these businesses may pass to the next generation, a large portion of them will be sold — many of them to an Employee Stock Ownership Plan, or ESOP. How do you know if an ESOP is a good option for your company?
 
An ESOP is a retirement plan that invests primarily — generally more than 50% — in the stock of the employer. It is a qualified, defined employee benefit plan that is governed by a trustee for the exclusive benefit of its participants. Because it is a qualified plan, it comes under the direction of the IRS and the U.S. Department of Labor. And though ESOPs can be relatively complex, they are often an excellent succession tool for a seller that can provide significant tax and intangible benefits. Some of these benefits include:
  • Sale structure flexibility. In a typical sale transaction, an owner will sell the entire company, either by selling assets or 100% of the stock. However, when selling to an ESOP, the seller can either sell 100% of the stock or a partial interest. This option gives the owner the opportunity to sell his or her stock over time while maintaining control of the business. 
  • Tax benefits. If the ESOP is purchasing stock from a regular C Corporation, the selling shareholders can use a 1042 rollover, named as such as it comes from Section 1042 of the Internal Revenue Code. This code section allows the selling shareholders to defer the gain on the sale of the stock, assuming that the ESOP purchases at least 30% of the stock by rolling the proceeds into other approved investments known as qualified replacement property (QRP).  These investments generally are limited to U.S. corporation stocks and bonds.
Another tax benefit of ESOPs is that the company’s payments to an ESOP are tax deductible. If an ESOP transaction is funded with debt, both the interest and principal payments are deductible for tax purposes. Typically, when a company borrows money, only the interest portion of the payment is deductible, therefore providing a significant tax savings.
 
If the company is structured as an S Corporation, the savings can be quite significant. An S Corporation does not pay taxes directly. Instead, any earnings of the company are passed through on a pro rata basis to the company’s shareholders, who in turn report the earnings on their individual tax returns. Because an ESOP is a tax-exempt trust, it does not pay any taxes on the earnings and distributions allocated to the ESOP’s shares. Instead, the ESOP can keep its portion of any distributions made for tax purpose and use them to service the ESOP debt or make repurchases of participant shares as needed. If the ESOP owns 100% of the S Corporation shares, the company and its sole shareholder pay no tax, giving the ESOP a significant advantage over its non-ESOP competitors, as it can use its enhanced cash flow in myriad ways, including making acquisitions and funding capital expenditures. 
  • Employee benefits. The employees of ESOP companies can benefit in many ways. In addition to receiving a retirement benefit at no cost to the employee, research by the National Center for Employee Ownership (NCEO) and others has shown that ESOP companies are more profitable, have better morale and lower turnover. As an example, employee owners are one-quarter to one-third less likely to lose their jobs compared to nonemployee owners. ESOP participants as employee owners have a vested interest in the performance of the company and are, thereby, incented to make the company better.
  • Community benefits. A sale to an ESOP — as opposed to an outside buyer — will likely keep the business and its jobs from moving out of the community that it serves.
ESOPs are well-suited for established companies that have shown consistent and predictable profits and are growing. An ESOP may not be a good option for a company that does not have these characteristics.
While the benefits of ESOPs are significant, there are some disadvantages as well. Because ESOPs are governed by federal agencies and regulations, establishing and maintaining an ESOP can be complicated. But these complications can be navigated with a team of experienced advisers, both legal and financial. Of course, good advice and counsel comes at a cost, but these costs may be comparable or lower than transaction costs in a typical business sale. There are ongoing costs to an ESOP as well, including annual fees for valuation, trustee fees — if trustee services are provided by an outside trustee — and administrative costs.
 
Another factor to consider is that the maximum price that an ESOP can pay is fair market value, which might be lower than what a strategic or synergistic buyer may be willing to pay. 
 
If you or someone you know thinks an ESOP might be a good exit strategy, a good next step would be to speak to someone knowledgeable in ESOP transactions, and the MNCEO (www.mnceo.org) would be a great place to start.
 
Patrick Schmidt is the president and the lead of business valuations services at Value Consulting Group. You may reach him at pat@valcongrp.com or 612-436-0559.
 
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 over the age of 55 in Minnesota exiting their business in the next 3–5 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 Sue Crockett, executive director at scrockett@mnceo.org.