While there are many ways to sell your company, one lesser-known but worthy option is to sell to an Employee Stock Ownership Plan, or ESOP. An ESOP, which is a qualified defined contribution plan set up as a trust, allows a company’s employees to buy portions of the company by acquiring shares of stock.
From a business perspective, there are a couple key objectives of an ESOP. It allows:
But there are many factors to consider when determining whether to sell your company to an ESOP, such as which type of ESOP to use, and the primary advantages and disadvantages compared to other types of sale transactions.
There are two types of ESOP transactions to be aware of: nonleveraged and leveraged.
A nonleveraged ESOP does not borrow money to acquire the shares of the seller. Instead, the employer will contribute the shares or cash to the ESOP on behalf of employees. This allows amounts to be allocated to the employees, where employees will “cash out” upon termination or retirement.
A leveraged ESOP is one in which the ESOP borrows money to buy the stock from the seller. This may be in the form of a note between the ESOP and the employer, or the ESOP and the seller. The shares of stock are then allocated to employees as the loan is paid down.
In both instances, the ESOP trust will own the shares while the employees participating in the plan receive the related benefits. A trustee is also required, acting as a fiduciary of the ESOP, to ensure the company acts in the best interests of the plan and its participants.
Consider some of the following pros and cons when deciding if an ESOP makes sense for your sale.
| Advantages | |
|---|---|
| Fair Market Price | The sale to the ESOP is based on a price that is at the fair market value, which allows for sale of the company at a comparable price that would be obtained if the company were sold to a third party. |
| Tax Deferral Opportunities | If certain requirements are met — including that the ESOP owns 30% or more of the company’s shares post-transaction, and the selling owner invests the sale proceeds into a qualified replacement property — selling shares of a C corporation can allow the owner to defer certain taxes. |
| Tax-Exempt Status | ESOPs are not taxable entities, and when coupled with S corporation status, the percentage of the company an ESOP owns is exempt from taxes. That status positively impacts overall cashflow and defers taxes on appreciation of the share price until the participant retires or leaves the company, requiring a repurchase of the shares. Note that while federal taxes are eliminated, the company still must pay property taxes and certain state and local taxes depending on the jurisdictions in which the company operates. |
| Substantially Reduced Tax Burden | The most significant benefit of an ESOP transaction occurs when the company is an S corporation and the ESOP owns 100% of the shares of the company, substantially reducing the tax burden and passing it along to the ESOP, which is tax exempt. That said, in the case of a C corporation owning the company, the conversion from a C to an S corporation can have certain complexities that require careful planning, as the conversion can trigger inadvertent tax consequences. For example, if the company is valuing inventory on the LIFO basis before the sale, the move to an S corporation would require LIFO recapture, triggering tax amounts due even after the ESOP owns the company. |
| Employee Motivation | Employee incentives can be incorporated within the ESOP, such as in the form of stock warrants or stock appreciation rights. This can help incentivize management, tying them directly to the annual share price via compensation that is in sync with the growth goals of the company. |
| Increased Employee Retention and Productivity | As employees will have a benefit that is tied to the overall performance of the company, this often creates a mindset of growth. An ESOP can also aid in employee retention, as the benefits of participating in the plan can increase over time as the share price grows, creating a meaningful retirement vehicle for employees. |
| Disadvantages | |
|---|---|
| Less Liquidity and More Responsibility | The liquidity obtained from the overall transaction is typically less than what you would receive from a third-party transaction. This is largely because many ESOP transactions are leveraged transactions, involving both bank financing and subordinated seller promissory notes that would be paid to the seller over a period of time. Any seller promissory note is subject to the timing of the pay back, which can be over multiple years, as opposed to a lump sum that could be obtained through a third-party sale. If the retained management of the company is not successful, the seller may also not realize the full value of the sale of the company. Bank debts taken out to finance the transaction may also require certain personal guarantees. So, while the company may owe the debt, if the company is not able to pay its future debts, the seller may be ultimately responsible. |
| Increase Administrative Duties and Cost | There are many administrative requirements that come with selling the company to an ESOP. First, you must have a board and a trustee to act as a fiduciary. Annual valuations are required to be performed related to the ESOP stock value, both from an ERISA perspective but also for any financial statement audit or review that is performed in accordance with U.S. GAAP. An ERISA audit may also be required to be performed by an independent accounting firm, depending on the number of participants. A third-party administrator must be engaged to maintain participant accounts. The cost of the transaction itself also involves numerous advisers, which can make the ESOP transaction cost prohibitive. |
| New Balance Sheet Liabilities | The accounting related to the transaction can be rather complex and result in substantial liabilities on the company’s balance sheet. For example, ESOPs can offer incentives to employees through stock appreciation rights and stock warrants, which derive their value from the underlying stock. As debts are paid down, assuming the company is growing, the share prices would also likely go up, thereby creating a substantial liability in the future depending on how these incentives are written. This can potentially impact covenants as well, depending on your bank agreements. |
| Cash Flow Considerations | You must carefully consider your company’s cash flow with an ESOP transaction. As there can be some notable benefits, such as reduced taxes at the company level, there may be additional bank debt and seller promissory notes that require additional cash outflows in the form of principal and interest. Also, as the value of the company increases, amounts owed for repurchases of shares of termed or retired employees will increase the cash outlays required, including amounts owed in the case of incentives such as warrants and stock appreciation rights settled in cash. |
| Retirement Account Ramifications | While the hope is that the company value continues to increase, if it falls significantly, it can have a material impact on employee owners’ retirement accounts. |
Selling your company to an ESOP is not for everyone. It is crucial to involve your tax team prior to a transaction to ensure you consider any tax ramifications well in advance. Depending on the size of your company, the administrative requirements and expenses may outweigh the potential benefits, and an outright sale to a third party may be the best route. However, an ESOP could also potentially be the avenue that creates a win-win situation for all involved, motivating employees while giving owners the exit they are looking for.
Contact Mike Demko at mdemko@cohencpa.com or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.