Michael TorneyCFP, J.D., LL.M. 

Business owners considering selling their companies usually have a few options – such as selling to a local competitor, family member(s), a large chain, or a private equity firm. But another lesser-known option is selling the business to your employees through an Employee Stock Ownership Plan (ESOP).

ESOPs are a type of qualified retirement plan. One of the most significant differences compared to selling to a third party is that it allows employees to buy stock in the company. It’s also a way for an owner to keep ownership among people you know and trust. In addition, you may be able to keep part ownership while maintaining a role in management.

While not the most common form of company ownership, ESOPs have found a niche. According to the National Center for Employee Ownership, as of 2019, there were approximately 6,500 ESOPs in the U.S., holding total assets of over $1.6 trillion.

How an ESOP Works

Under an ESOP, the new company sets up a trust funded with either newly issued shares of the company or cash to buy shares of the company. The ESOP holds the company shares in trust as an investment for the ESOP participants’ benefit. The money can come from the company directly or through a loan.

There are plenty of reasons to sell your business to an ESOP – but there are also many reasons to sell to a third party. Here are some of the key issues to consider.

The Selling Price of the Practice

Under federal law, an ESOP can only pay a fair market price for your business. However, a competitor or other outside buyers are allowed to pay more than the appraised value of the practice. The winner will likely be willing to pay a premium to acquire it if there are multiple bidders for your business. If the owner stands to make considerably more money by selling to a third party, it’s certainly worth considering this option.

Taxes: Many third-party sales may be treated as a combination of ordinary income and capital gain. ESOP transactions, on the other hand, are taxed as capital gain. Certain ESOP transactions will allow the seller to defer and potentially eliminate the capital gains taxes.

How You Will be Paid. An outside bidder tends to offer a larger up-front payment and make the remaining payments over a short period. On the other hand, ESOPs often pay the seller through a note payable over many years.

Impact on Your Employees and Your Business. Considering a sale to an outside company means that any potential bidder will have access to your financial statements and other confidential documents. So, if you decide not to sell to one or more competitors, they may now have detailed information about your business.

Next, suppose an outside company is an eventual buyer. In that case, they could decide to place their own people in key positions and lay off several current employees. And for the employees who remain, there are other potential problems.

These third-party sales agreements often pay the employees in the form of “earn-outs,” which is a future payment if the business meets certain financial goals. The employees will likely be required to take a “rolling equity” in the business, which means they must roll a portion of their ownership into the business after it is acquired instead of receiving cash.

On the other hand, since an ESOP consists of the current employee base, those employees will likely be interested in maintaining the business practices and culture you have established over the years. The workforce will be motivated to continue to perform well and grow since many are now part owners.

For owners who want to continue to stay involved, there is this benefit: they can be designed to retain control of the business and its management.

Other Issues for ESOPs

Financing must be lined up if you decide to form an ESOP. And once the ESOP is up and running, someone needs to administer it.

The good news is that financing is often available at attractive terms. An ESOP also has tax benefits that an outside, third-party buyer often can’t match.

Your business may be able to take income tax deductions up to the total amount of the ESOP sale price, and you may also be able to eliminate any capital gains taxes. There are also benefits for your employees, who can roll their ESOP stock sale proceeds into another qualified retirement account.

ESOP Drawbacks

There are some issues to navigate that require constant oversight:

  • ESOPs are complex. Once up and running, an ESOP requires someone to administer its multiple expenses, ranging from trustee fees, annual valuations, plan administration, and legal fees. This may include monitoring and paying any shareholders who sold their shares to provide part of the financing for the sale.
  • ESOPs are best suited to companies with predictable cash flow. Since most ESOPS are financed with loans (i.e., a leveraged ESOP), a highly cyclical business might not be a good candidate.
  • An owner must be confident that the next generation of leadership can effectively run the company after their retirement. If the current owner wants to retire quickly and no clear successor is ready to take over, an ESOP might be the wrong solution.
  • An ESOP doesn’t provide as large of an upfront cash payment that private equity or a strategic buyer typically offers. A third-party sale might be a better fit if the owner requires most of the cash upon closing.
  • An ESOP competes for company revenue. If the company needs that revenue for other business needs, the ESOP transaction must be carefully analyzed before moving forward to ensure the business continues to operate smoothly.

Take some time to meet with the right advisors

Before deciding on how to pursue a sale, the right team should be called in to discuss the pros/cons of the ESOP. Typically, that team consists of a CPA, financial advisor, valuation company, ESOP attorney, and investment bank that can help lay out the economic benefits and drawbacks of an ESOP. With that information, you can determine if it’s the right course for you.

Have Questions?

If you have questions about selling a business to an ESOP and want to discuss a strategy, contact us.  We offer a free consultation to help discuss how we may be able to help accomplish a smooth purchase that is incorporated into your overall financial plan.

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