The Pros and Cons of ESOPs

Business owners who want to monetize their hard-earned equity, or step away from their companies, have several M&A options.

Many immediately gravitate to third-party sales. A transaction with either a strategic or financial buyer (such as private equity) may offer a clean break and a chance to cash out.

However, there are trade-offs:

• Capital gains taxes will be due on the sale amount
• Employees may be laid off
• Earn-outs or rolling equity requirements are common
• The business’s ongoing legacy will likely be determined by someone else
• The process alone may expose confidential information to competitors

For some business owners, these drawbacks are too much to bear. That’s where employee stock ownership plans come into play.

Thousands of companies, from across the country, have turned to ESOPs as tax-advantaged liquidity alternatives. For many closely-held businesses, employee ownership offers independence, flexibility, and legacy preservation.

But like any transaction, an ESOP carries its own advantages and potential downsides. It’s worth internalizing these pros and cons if you’re considering an employee stock ownership plan for your closely-held company.

PRO:  Sellers are Paid Fair Market Value (FMV)

The Internal Revenue Service defines FMV as the price a company would sell for on the open market. “It is the price that would be agreed on between a willing buyer and a willing seller, with neither being required to act, and both having reasonable knowledge of the relevant facts.”

An ESOP trustee has a fiduciary responsibility to uphold this standard. FMV is derived through an independent valuation, followed by negotiations between a plan’s sponsor and an ESOP trustee. The transaction is only consummated if both sides agree on a price. Overall, a company and its shareholders can count on fair compensation for their equity.

CON:  ESOPs Cannot Offer More than FMV

Sometimes, an acquisition target offers unique synergistic benefits. Some companies are ideally suited to meet certain acquirers’ vertical integration, horizontal expansion, or market share goals. If a strategic buyer believes the transaction will drive economies of scale, that company may pay a premium that exceeds the FMV price offered by an employee trust. Although an ESOP’s tax advantages can help close or eliminate this gap, in terms of post-tax sale proceeds, there are occasions when a strategic sale will be the most financially advantageous option.

PRO:  An Employee Trust is a Known Buyer

M&A due diligence can leave a seller exposed. Even if a sale isn’t consummated, sensitive corporate information and trade secrets can be revealed to competitors. Although a leveraged ESOP transaction should be subject to a similar, rigorous fact-finding process, the buyer – an employee trust – ultimately has the company’s best interest in mind. The cornerstone of a successful employee stock ownership plan is a stable and prosperous plan sponsor. A professional ESOP trustee is obligated seek fair market value, but not at the expense of company’s reputation or future prospects.

CON:  An ESOP Transaction Process is Highly Structured

ESOPs are regulated by the US Department of Labor, with formal rules and restrictions codified by the IRS. As a result, employee ownership transactions feature complexities that aren’t often encountered in typical M&A deals.

In addition to working with designated specialists (an institutional trustee, trustee’s counsel, and an independent valuation firm) the process includes unique steps, such as determining which employees participate and authoring an ESOP plan and summary description. There’s also the added need to educate staff about their new benefit plan. All this underscores the importance of working with experienced employee ownership professionals. Despite these nuances, the cost to complete a leveraged ESOP sale is usually less than the costs associated with M&A or private equity translations.

PRO:  Non-Recourse ESOP Financing is Available

Many commercial lenders are attracted to ESOPs. The associated tax incentives (see below) drive increased cash flow, while companies with strong employee ownership cultures statistically outperform their peers. Senior debt, offered without personal guarantees and at reasonable terms, can often finance a sizable portion of a leveraged ESOP transaction. Higher-interest rate mezzanine debt is also available in situations where additional up-front cash is needed. Employee-owned companies repay these loans with pre-tax corporate cash.

CON:  Selling Shareholders Often Provide Partial Financing

Although third-party ESOP lenders are plentiful, most transactions include a seller note component. The extent of seller financing often depends on a company’s fundamentals and industry. Some businesses also prefer a transaction that’s exclusively seller financed.

Selling shareholders with the sole goal of maximizing their cash at closing may be better served in a private equity sale. Nonetheless, their capital gains will be taxable, and sellers may be required to roll equity into the deal.

PRO:  Tax Benefits for all Stakeholders

Since passage of the Employee Retirement Income Security Act of 1974 (ERISA), Congress has formally encouraged the establishment of employee-owned companies. With working class wealth creation and middle-market business stability as goals, substantial ESOP tax incentives were included in the landmark legislation and have since been expanded by lawmakers from across the political spectrum.

All ESOP stakeholders are entitled to tax breaks:

• Sellers can blunt or eliminate capital gains tax burdens with a 1042 rollover
• Companies earn income tax deductions equivalent to their ESOP sale price
• 100% employee-owned S corporations pay no income taxes in most jurisdictions
• Employees can roll their ESOP stock sale proceeds into another qualified retirement account

CON:  ESOPs Require Ongoing Maintenance

Because an ESOP is a qualified retirement plan, albeit one that invests primarily in employer securities, these plans also fall under the jurisdiction of the ERISA. In addition to issuing formal rules on stock allocations, vesting, and repurchases, the DOL requires plan sponsors to run annual, independent valuations and submit a Form 5500.

Like other defined contribution plans, including 401(k)s, a third-party administrator (TPA) handles day-to-day oversight of the plan. Annual statements, vesting schedules, and share repurchases are also managed by the TPA. The associated costs are in line with other contribution plans.

PRO:  Independence, Upside, and Flexibility

Unlike an outright third-party sale, an ESOP transaction can help ensure continuity of leadership while maintaining the legacy of a business. Sales of minority interest are common, and shareholders are still entitled to capital gains tax deferrals, so long as at least 30% of the company is sold to an employee trust. Even in the event of a majority or 100% ESOP sale, a company’s board of directors will continue to operate the business. In all scenarios, selling shareholders can maintain meaningful roles with their companies. That keeps founders and key members of family businesses in the fold.

When ESOPs prosper, that upside is available to all stakeholders. Vested employee owners, and shareholders with retained interest, tangibly benefit from a company’s growth. Selling shareholders may also receive synthetic equity (or warrants) as part of an ESOP transaction. As a result, they too can maintain upside potential.

Finally, it’s important to note that an ESOP isn’t necessarily an end-all-be-all transaction. Secondary ESOP sales and share buybacks are common next steps. An employee-owned company can even opt to engage in M&A. Of course, if an ESOP company is sold, employee owners reap their share of the proceeds. That can turn a commonly negative event for employees to a positive, life-changing experience.