ESOP, An Exit Option To Consider For These Times

By Bill Quish, Mergers & Acquisitions Advisor and Certified Exit Planning Advisor (CEPA)

What seldom understood exit option should a business owner consider when?

A Letter of Intent serves many purposes besides documenting the business deal, including the following:

  • The owner has an important need for partial or full liquidity
  • Market conditions just aren’t right for achieving a strategic premium from a third party buyers
  • Selling the company to the management team or a third-party is not feasible

The answer is a leveraged Employee Stock Ownership Plan (ESOP). An ESOP can be a useful tool in facilitating the sale of a business. ESOPs provide a business owner with the ability to receive partial or full liquidity. They were designed by Congress as a way to encourage owners to put ownership of their businesses into the hands of American workers while retaining control and achieving significant tax advantages for both the owner and the Company. Today, ESOPs comprise over 10,000 U.S. companies and over 11.5 million workers. Companies with predictable revenue and cash flow and a balance sheet to support additional financing are the most attractive candidates for an ESOP.

ESOP Structure Overview

According to Richard Glassman of Schatz Law Offices in West Hartford, Connecticut, an attorney specializing in ESOP transactions, “there are a number of innovative ESOP structures being employed today. Tax deferred rollovers, warrants to provide upside compensation, long term employment contracts and participation in the on-going ESOP are just a few of the arrangements that can be put in place to maximize the return to the selling shareholder. Additionally, if a Company becomes 100% owned by the ESOP and elects to be taxed as an S Corporation, it essentially becomes a tax free – for profit entity. Funds that would have been allocated to federal and state income tax liabilities could then be employed to reduce debt, purchase equipment, make acquisitions or in other ways grow the business.”

An ESOP is by law a retirement plan that has as its principal investment asset the Company’s stock. To fund the purchase of it’s shares by the ESOP, the Company borrows money from a bank, an alternative financing source or from the selling shareholder (or from a combination of sources). The Company then lends the borrowed funds to the ESOP. Since an ESOP transaction is a form of leveraged buy-out (LBO), the size of the loan received is largely a function of the Company’s debt capacity. The owner’s stock is then purchased by the ESOP with the funds lent to the ESOP by the Company.

The ESOP creates individual accounts for each participant (employee). The accounts hold the stock allocations for the participants. As with most retirement plans, the shares in the individual accounts vest over some prescribed period. The cost to the Company is the annual cash contributions to the ESOP. These cash contributions (pension plan expense) are received by the ESOP and then used by the ESOP to repay the loan made to the ESOP by the Company. In the end, there is no cash flow impact to the Company and the Company generates a tax deduction for the amount of the contribution. The Company can then, if necessary, use the same funds to pay down the loan that it received from the outside sources of financing.

Each payment made by the ESOP allocates a portion of the stock in each participant’s account. Typically the employees receive the cash value of the stock in their individual accounts when they retire. The long-term cost to the Company is the Company’s obligation to repurchase, over a five or ten-year period, the employee’s allocated and vested shares upon retirement or termination of service.

Primary ESOP Advantages

For the Owners (Existing Stockholders):

  • Creates liquidity at a fair market value price
  • Control of the company can be maintained
  • Tax-free rollover treatment is available
  • Keeps the company in the extended family
  • Negotiations for the sale are with a “friendly” buyer

 For the Company:

  • Pre-tax dollars repay both the principal and the interest on the debt
  • ESOPs motivate employees and thus can improve Company performance
  • Control of the Company remains with the board of directors and management team -- ESOPs are not intended to, and do not (unless desired), affect the management of the business
  • A 100% ESOP-owned S Corporation pays no federal or (in most cases) state income taxes

 For the Employees:

  • Employees, as beneficial owners, share in the equity growth of theESOP Company
  • Contributions to the ESOP are tax-sheltered for employees
  • Employees do not pay taxes on the increase in value of their stock until they cash-out (tax free rollovers to an IRA are permitted)
  • Employees, though benefiting from the growth in the value of the business, are not personally responsible for the Company’s debts

 Primary ESOP Disadvantages

  • May not enable an owner to exit in one transaction
  • As with most pension plans, there are annual administration costs
  • ESOPs are leveraged buy-out transactions; borrowing against the Company’s future earnings to purchase the owner’s shares
  • The Company has created a long-term benefit plan which must be funded.  Initially, the funding repays the loan taken to purchase the shares.  In the long run, the funding cost is incurred to repurchase the shares from retiring employees
  • The owner may have to sign personally for the bank loan, but can maintain voting and operating control

If an ESOP is of interest to you as a means of achieving liquidity, the first step is a discussion with a qualified ESOP advisor. This may then lead to a formal feasibility study. This study will inform the owner whether the characteristics of the Company taken into consideration with his or her goals and circumstances are such that he or she is a good candidate for a sale to an ESOP. The feasibility study should include a written analysis prepared by an attorney or a financial advisor.
 

Bill Quish is a Mergers and Acquisitions Advisor and Certified Exit Planning Advisor (CEPA). He is a Senior Managing Director at Lyons Solutions, LLC. He can be reached at 860-391-8672, bquish@lyonssolutions.com or bill@mergermaven.com.

Copyright 2010 Bill Quish. All Rights Reserved.