What’s an ESOP, & Why are they Continuing to Gain Popularity as an Exit Strategy

When Your Legacy And Your Employees Matter Most, Consider an ESOP

When you think of selling your business, you probably think of locking the doors one late afternoon and then handing the keys over to someone else. That might be a competitor, a private equity fund, or a strategic buyer. 

Or maybe you picture liquidating the assets. You’d rather see your equipment carry on in a new home, with a new purpose. 

However you envision walking off into the sunset, it’s hard to think of letting go of all those years of work: handing them over to someone else or watching them dissolve into the wind. 

Recommended Read: Too Soon? When is the Right Time to Start Exit Planning?

There’s a different option that many business owners aren’t familiar with because it’s a complicated strategy that involves some financial and legal maneuvering. But selling to an ESOP (Employee Stock Ownership Plan) just means selling your shares of your company and staying on to run the business if you’d like, while your employees receive a long-term retirement benefit at no cost to them.

This is a powerful way to preserve your legacy and protect the employees you care about. 

Read on for the details: it involves some knotty financial and tax strategies, but dive in if you like to get the nitty-gritty! A complicated transaction like this would be handled by an excellent team of financial strategists and CPAs. (Yes, this is something Doescher Group can help you with: Contact us for a consultation if you’re curious if an ESOP is right for you.) 

Recommended Read: What’s Going to Happen to My People When I Sell?

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What is an ESOP?

An exit strategy that’s gained momentum is a sale of the company to an Employee Stock Ownership Plan (“ESOP”). While some business owners may have heard of employee ownership, many are never exposed to the details of a transaction. An ESOP is a type of qualified retirement plan that invests primarily in the stock of one company. An ESOP provides business owners with an opportunity to be actively involved in the future of the business while offering employees a vested interest in the company and preserving the legacy built over many years.

While motivations for any business owner pursuing a particular exit strategy may be different, below is a list of popular reasons business owners decide to sell to an ESOP.

Ensure a Solid Succession Plan For Your Business with an ESOP 

An ESOP provides business owners with a market for their shares outside of selling to a competitor or private equity fund. Typically, the business owner remains with the company after selling their equity and receives value for their shares over several years (either through multiple transactions or payments on a seller note), during which they can continue to participate in the operations. The option of establishing an ESOP can be attractive to business owners that may not have an “heir apparent” to take over the business or to business owners that are not interested in going through a sale process involving a potential competitor or private equity fund.

Tax Advantages

An ESOP provides business owners of C corporations (or an S corporation that has revoked its S corporation election) the ability to defer taxes on a sale of equity to an ESOP via a tax election made available through §1042 of the Internal Revenue Code[1]. The seller must reinvest the sale proceeds in qualified replacement property within 12 months of a sale and would be taxed upon disposition of that property. However, if structured properly, the taxpayer may avoid paying all long-term capital gain taxes associated with the sale.

In addition to the tax benefits available to sellers, the company can benefit from tax-deductible contributions to an ESOP in the form of principal and interest payments in a leveraged transaction. If the company is an S corporation and sells 100% of its stock to an ESOP, the company and the ESOP typically do not have any income tax obligation – since the ESOP, as the sole (tax-exempt) shareholder, is recognizing flow through earnings resulting in no tax obligation.

Photo by Pavel Danilyuk: https://www.pexels.com/photo/photo-of-people-shaking-hands-8112186/

Employee Benefits

Upon the formation of an ESOP and completion of a transaction, employees will receive a tax-deferred benefit over several years by receiving an allocation of the acquired shares to accounts for their benefit. These accounts are tax-deferred, and the employees are not required to contribute to receive shares. This offers employees of the company an additional benefit that increases employee morale and retention of existing employees and also attracts new employees.

Flexible Structures

The sale of a company to an ESOP can be structured in a manner that allows for the acquisition of a minority, majority, or 100% interest in the outstanding shares from a business owner. This flexibility allows owners to participate in the potential appreciation of company value if they sell less than 100%.

For a shareholders to receive cash for their sold shares, the company will typically obtain outside financing from a lender. If third-party lender financing does not cover the entire value of shares being acquired, the remainder is typically acquired by utilizing seller financing. When seller financing is utilized, it can provide the shareholder with additional returns above the sale price of their shares.

Ongoing Role and Less Operational Interruption

Typically, after a sale to a strategic buyer or a financial buyer, time will be spent on integration, and the buyer may also engage in cost-cutting measures or eliminate positions. After a sale to an ESOP, the business operations can continue uninterrupted, and little is changed operationally.

Due to a more seamless transition, business owners are often comforted that an ESOP transaction ensures employees will keep their jobs, receive an additional benefit, and business will continue as usual. If a business owner also holds an executive position in the company, by selling to an ESOP, the business owner can retain their position, unlike the uncertainty created in a sale to a strategic or private equity buyer.

All of these features can make an exit to an ESOP more attractive to business owners. If nothing else, it is another exit strategy that should be considered among others when the time is right to sell your business. Contact Doescher Group if you’d like to learn more about how an ESOP could benefit you and your business. 

[1] Additional criteria must be met to qualify for a §1042 rollover, including the ESOP owning greater than 30% of the stock, ownership of equity must be for at least three years before sale, and specific qualified replacement property categories must be met, among others.