In our last two blogs, we discussed the merits of two options available to exiting business owners who wish to transfer their business to key employees. First, we wrote about the option of the Long Term Installment Sale, which allows one or more employees to sign a promissory note, effectively setting up a payment plan to cover the sale price over a period of seven to ten years.
This was followed by Part II of this series, in which we examined the option of the Leveraged Management Buyout, which allows your company’s management team to finance the buyout of the business.
Now, we’re going to look at the option of ESOP’s, or Employee Stock Ownership Plans. This is a popular choice for many business owners, and not just as part of their own exit and transition from the business.
EMPLOYEE STOCK OWNERSHIP PLAN (ESOP)
An ESOP is a tax-qualified retirement plan (profit sharing and/or money purchase pension plan) that must invest primarily in the stock of the company. In operation, it works just like a profit-sharing plan: the company’s contributions to the ESOP are tax-deductible to the company and tax-free to the ESOP and its participants (who are essentially all of the company’s employees).
In the context of selling at least part of the business to the key employees, the ESOP is used to accumulate cash as well as to borrow money from a financial institution. It uses this money to buy the business owner’s stock. Provided certain additional requirements are met, the owner can take the cash from this sale, reinvest it in “qualifying securities”—publicly traded stock and bonds—and pay no tax until he sells those securities.
The participants in the ESOP then own, indirectly, the stock purchased by the plan. Key employees will likely own a significant part of that stock because ESOP allocations to participants are based on compensation.
Typically, however, key employees will want more than indirect ownership. They will want to control the company and have the possibility of owning a disproportionate amount of the company by purchasing stock directly from the owner before the owner sells the balance of this stock to the ESOP. By owning all of the stock not owned by the ESOP, the key employees can effectively control the company. The net result is an ownership structure not unlike the management LBO. An ESOP, rather than an outside investor, owns and pays cash for a majority interest in the company. The existing management operates the business and has significant ownership. The owner is largely cashed out of the business, perhaps having to carry only a portion of the purchase price of the stock sold to management.
There are substantial financial and other costs associated with an ESOP; after all, there is a reason that there are fewer than 25,000 active ESOPs. The benefits and limitations of ESOPs are described in our ESOP blog. For now, consider it a method worthy of exploration with your legal, tax and financial advisors.
In the fourth and final installment of this blog, we’ll share some information about another option available to exiting business owners; that of the Modified Buyout.