Having a sound exit strategy in place with respect to departing shareholders is imperative for any company. This is especially true for small businesses in which the departing shareholder is a key cog in the company’s management and day-to-day operations. A departing shareholder also faces the issue of finding a market to be adequately compensated for his shares.
“Companies and individuals are faced with the daunting task of finding a market for the shares being sold, the fear of a targeted acquisition in which the purchaser would drastically alter the landscape of the company, and the various costs and time associated with the transaction,” says Matthew P. Breuer, J.D., an associate with Cendrowski Corporate Advisors LLC.
Accordingly, this has caused companies and shareholders to look elsewhere from traditional buy-outs for this transition. One solution that the individuals have turned to is implementing an employee stock ownership plan (ESOP).
Smart Business spoke with Breuer about the benefits of ESOPs and how they’re implemented.
Smart Business spoke with Breuer about the benefits of ESOPs and how they’re implemented.
What makes an ESOP unique?
An ESOP is essentially an employee benefit plan in which employees can acquire ownership of the company for which they work through a qualified retirement plan. One of its defining characteristics is that an ESOP is the only qualified plan permitted and required by law to invest primarily in the stock of the sponsoring employer.
ESOPs also offer attractive options with regard to obtaining financing and tax planning for different types of entities. Securities acquired by an ESOP are held in a trust and the employees will be the beneficial owners of the value of the stock despite not having to invest their own money. According to a 2010 survey by the ESOP Association, there were approximately 10,000 ESOPs in place in the U.S. covering roughly 10.3 million employees, which is approximately 10 percent of the private sector workforce.
Why have so many companies turned to these types of plans?
ESOPs have become viable options as exit strategies for shareholders for a variety of reasons. For a departing equity holder, implementing an ESOP creates a ready market place in which the shares can be purchased, thus eliminating the need to find a willing buyer. An ESOP is also advantageous in that, among qualified employee benefit plans, an ESOP is allowed to borrow funds to finance an acquisition.
This is an attractive option to companies that may need capital to acquire the stock. Implementing an ESOP also allows a company to receive significant tax and financial benefits. Among the numerous benefits, the dividends paid on stock held by the ESOP are fully tax-deductible, the principal can be repaid with tax- deductible funds, and the owner can choose what portion of his or her stock to sell.
The transaction costs associated with ESOPs are also comparable to traditional buy-outs.
How does an ESOP transaction work?
Most often a company will elect to obtain financing through a third party, which is known as a leveraged ESOP. Stated simply, a bank will lend money to the company and the ESOP will then buy stock from the company or the shareholder(s). The company in turn will make annual tax-deductible contributions to the ESOP, which will repay the bank for the original note. Employees will then receive stock or cash when they retire or depart from the company.Under certain circumstances,
selling shareholders can defer the entire gain recognized from the sale of shares for federal income tax purposes.
selling shareholders can defer the entire gain recognized from the sale of shares for federal income tax purposes.
What makes a company an ideal candidate to implement an ESOP?
ESOPs are effective exit strategies, particularly with smaller companies. They can serve as an effective method of transition by having a purchaser already lined up and selling the stock in a tax efficient manner. Smaller companies also have the ancillary benefit of motivating employees through an ESOP purchase. To correctly adopt an ESOP, you need to have a team in place that has experience with finance, legal and tax support, benefit plans, and can coordinate effectively. ●
Matthew P. Breuer, J.D., is an Associate with Cendrowski Corporate Advisors LLC. Reach him at (866) 717-1607 or [email protected]
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