As baby boomer business owners age, there is a pressing need to select their business exit strategy. One option is an employee stock ownership plan (ESOP), where the business owner sells the company — up to 100 percent of the stock — to the employees.
If you sell 30 percent or more, there are tax advantages that could mean that you end up with more after tax proceeds than selling to an outside party. This is nice, but often the bigger benefit is your legacy.
“If you sell to an outside third party, whoever buys it can do whatever they want with your business, and they may not maintain the employees or your business philosophy,” says Tim McDaniel, CPA/ABV, ASA, CBA, director of business valuations at Rea & Associates. “But with an ESOP, your business philosophy usually continues, and the employees continue to have jobs.”
At the same time, the employees get ownership, which motivates them to put in the extra effort and work as a team to build their own stock value. They have more pride going to work, and many long-term employees can retire with a nice nest egg if the company does really well, he says.
Smart Business spoke with McDaniel about which companies may be right for an ESOP.
Have ESOPs become more popular?
They haven’t exploded in popularity, but ESOPs are more popular today than they were a few years ago. In the past, the complexity intimidated business owners, and many lenders were reluctant to fund ESOPs. This has changed as knowledge about how ESOPs work has grown.
How are ESOPs different from employee stock option plans?
In an ESOP, which is most often an exit strategy, all employees own stock — although compensation and longevity will determine how much. An ESOP gives certain employees the right to buy stock. The key word is ‘certain.’ Usually, the company offers top-level employees stock as a short-term incentive.
What organizations are best suited to become ESOPs?
ESOPs are costly to establish because you need to hire an attorney, trustee and valuator. Therefore, they aren’t a good idea for companies without very much profit. A good rule of thumb is that you need at least $500,000 in ongoing profit for it to make economic sense.
In addition you need a strong management team. An ESOP is a leverage transaction and requires a bank loan. It’s important to have a leadership team that is able to manage the business and pay back the loan over time.
A stable workforce with little turnover is also important. The ESOP pays employees, usually over a period of five years, when they quit or retire; and it’s usually a large portion of their retirement plan.
Are there any disadvantages to ESOPs or risks that you should guard against?
Like any owner, the employees face the same advantages and disadvantages of owning a business — there’s higher risk and reward.
Some ESOPs replace other retirement plans for employees and if all of their retirement is in your company stock, they can be severely hurt if the company doesn’t do well or goes bankrupt. Don’t encourage this. You’ll want to allow for some diversification in the employees’ retirement.
The Department of Labor and IRS regulate ESOPs, so there will be more oversight from outside parties. Also, with new shareholders, some things like how much money you and the company makes is available to your employees. An ESOP might be your best exit strategy if you would like your legacy to continue and your employees to act like owners, and you don’t mind the additional oversight and cost.
Also, remember that you aren’t locked into an ESOP forever. If the ESOP no longer meets the needs that it was set up for, you can terminate the plan. But just like establishing an ESOP, it’s not cheap.
If this sounds like something that might work for your company, what’s the first step?
You’ll want to have somebody come in and do a feasibility study of what it actually would look like for your business. The study will determine what the value would be and what after-tax proceeds a business owner could expect. Then, you can determine whether to proceed, go another way or defer until your business is healthier.
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