Your client is interested in an ESOP: Why do they need a feasibility study?
By Kyla Hansen, CPA, John A. Knutson & Co., PLLP
February 3, 2022
An employee stock ownership plan (ESOP) can be a great way for a business owner to transition their business and give back to their employees. But it’s not ideal for everyone. Before you move forward with an ESOP, it’s wise to crunch some numbers to make sure it is a viable option.
Before diving into a feasibility study, we recommend taking a step back and looking at the big picture. Below are some key high-level considerations you can discuss with your client. In addition, you can reach out to the Minnesota Center of Employee Ownership (MNCEO) for a list of professionals who are familiar with this topic.
- What are their goals for the transition? Do they want to maximize their proceeds? Do they want to leave a legacy, give back to their employees or ensure the business stays in their community?
- Is payroll large enough? A rule of thumb is that you need at least 20 employees to become an ESOP. The reason for this is that an ESOP is another form of retirement plan and the annual contributions cannot be larger than 25% per year, however there are some exceptions to this rule. A feasibility study can go into more detail in this area.
- Is the seller planning to exit the company post transaction, or will they continue to work there? What is the strength of their management team and is the seller comfortable with the idea of employees as owners?
- Recommend a high-level analysis to determine the company’s estimated value. Also consider modeling out what this means in terms of after-tax cash flow to the seller.
- Consider if the company can afford the ESOP contributions and expenses?
- A rule of thumb is the company should have earnings with interest, taxes, depreciation and amortization (EBITDA) of at least $250,000.
- Transaction costs of becoming an ESOP can be $100,000 or more depending on complexity. However, this cost may be comparable to paying broker fees to sell a company.
- There are ongoing expenses for an ESOP such as an annual review or audit of the financials, an annual valuation, independent trustee fees and third-party administrator (TPA) fees.
- Cash flow to pay for a loan as a result of the buyout.
What is an ESOP feasibility study?
Simply put, an ESOP feasibility study evaluates certain metrics and aspects of a business to determine if becoming an ESOP makes sense. The study allows an owner to know if becoming an ESOP is not only feasible but also in line with their goals — before they get too far into the process.
If, after this initial analysis, they decide to continue on the ESOP path, it is recommended to conduct a feasibility study from a service provider that has experience in this sector. The MNCEO can provide contact information for professionals that provide this service. A feasibility study may focus on topics such as the following:
- An in-depth analysis of the value of the company (interviewing management, detailed analysis of historical financials as well as financial projections and reviewing business plans).
- Mark up of what the financials of the company would look like, as well as forecasts for the future years including a future value calculation.
- An analysis of the employee wage and benefit levels needed to support the ESOP (IRS retirement plan limits apply).
- Determining the structure of the transaction.
- Financing considerations.
- A cash flow analysis of the company.
- After-tax cash flows to seller.
- Consideration of a future repurchase liability as employees retire or leave the company, including impact on the company’s cash flow.
As you can see there are many components and levels of detail you can incorporate in determining if an ESOP is feasible for a company. The key takeaways to get a handle on include:
- What extra cash flow does the company have that can be utilized in becoming an ESOP and supporting the ESOP?
- Is the anticipated after-tax dollars to the seller a sufficient amount for the seller to be willing to proceed with a transaction?
- Is there enough payroll to support the value of the ESOP contributions? Also be sure other retirement benefit plans contributions are included if they are going to be ongoing.
An ESOP isn’t your client’s only employee ownership option
If an ESOP isn’t ideal for your client, consider looking into alternative solutions. Two that also allow you to give back to employees are a worker owned co-op and an employee ownership trust (EOT). These options do not have the tax advantages that an ESOP has but they do provide a path to meeting the goals of the owner.
Look before you leap
As mentioned, it’s wise to make sure an ESOP is right for you or your client before jumping headlong into the process. Becoming an ESOP requires assistance from a variety of professional advisors — and their fees can quickly add up. An ESOP feasibility study and preliminary analysis can help your client explore their options.
Kyla Hansen, CPA, is a partner and heads the audit and assurance services department at John A. Knutson & Co., PLLP (JAK). You may reach Kyla at khansen@jakcpa.com.
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 www.mnceo.org or Sue Crockett, executive director at MNCEO scrockett@mnceo.org.
