By: Robert Grote, CPA, Partner, Manufacturing & Distribution Practice Leader
In business, timing is everything, even when it comes to your business’ exit strategy. The best strategies used years ago are not necessarily the best strategies to be used today. Years ago, there were many viable options available to owners, but in today’s economy, many of those options are no longer available or are less favorable to business owners.
With current market conditions, there are fewer acquisitions of private businesses by public companies. Private companies are no longer being sold for large multiples of earnings, and current management typically does not have the financial capacity to fund buy-outs. That is why an Employee Stock Ownership Plan (ESOP) may be the right exit strategy for you. It is estimated that over 10 million employees in over 11,000 companies, most of them closely held, participate in ESOPs, so it is a widely used exit strategy, as well as an excellent method of giving employees ownership of a company. Are you approaching retirement age? Do you have an exit plan in place? Is all of your net worth tied up in your business? If you answered “yes” to any of these questions, then now is the time to consider an ESOP. The following will overview the process, its benefits, and the steps and criteria necessary to make the program successful.
An employee stock ownership plan (ESOP) is essentially a type of tax-qualified employee pension plan in which most or all of the assets are invested in the employer’s stock. Like profit sharing and 401(k) plans, which are governed by many of the same laws, an ESOP generally includes full-time employees who meet certain age and service requirements.
Employees can acquire shares and ownership through an ESOP that range from 1 percent to 100 percent. Employees usually do not actually buy shares in an ESOP. Instead, the company contributes its shares to the plan, contributes cash to buy its stock (usually over several years for a gradual sale), or, more commonly, uses money borrowed from a bank or other financing source to buy the stock with the loan being repaid with employer contributions to the ESOP.
When outside funding sources are used it is called a leveraged ESOP buy-out. This is common because few companies have the cash on hand necessary to fund a significant buy-out. The company uses proceeds from a bank loan to make the loan to the ESOP. The ESOP buys shares of stock from existing shareholders. The value of the shares is determined by an independent business valuation. The company makes tax-deductible contributions to the ESOP, which the ESOP uses to repay the initial advance from the company. Annual contributions are limited to 25% of the eligible compensation of qualified employees; so obviously, the more employees participating, the larger the annual contribution. The company then takes the repayments from the ESOP and uses it to fund the debt service on the bank loan. Using a leveraged ESOP allows the owners to take all the cash up front. When the owners are paid a lump sum of cash they can use it to purchase qualified replacement property, which can defer the capital gains tax on the sale of the business. This deferral can be permanent. In addition, the owners can borrow against the qualified replacement property, allowing them to make other investments of their choice. Additionally, the stock purchase is done with pre-tax dollars, which reduces the cash flow required to fund the buy-out by almost half. Other benefits of using an ESOP as an exit strategy include the fact that it allows for the continued existence of the organization, allows employees to build value in ownership of the company, and provides owners with a way to cash out without giving up control of the company.
How do you know if your company is a good candidate for an ESOP program? The best way to determine this is to speak with an accountant who has a solid understanding of your company and the options available to you. In general, if your company meets the following conditions, ESOPs could be your ideal exit strategy: strong cash flow, good history with lending sources, a solid client base, competent second tier management, a broad base of employees to be included in contribution calculations, and no licensing requirements relating to ownership.
If your company meets all or most of these conditions, then ESOPs may be an attractive option.