Smart Business spoke with Solomon about how to decide if an ESOP is right for your company and how the economic downturn has made ESOPs an effective option for ownership succession of privately held companies.
How does a business owner determine whether to set up an ESOP or to sell the company to an outside third party?
The first thing any business owner needs to do when thinking about ownership succession is to determine what their objectives are in initiating a sale of their company.
Certain business owners want to get the highest value from the sale of their company and are not concerned about what happens with their business after they sell it. However, many owners of closely held companies look at their business as their baby — something they’ve built, nurtured and grown through their own blood, sweat and tears.
These business owners are not necessarily looking for the highest price but are interested in seeing their company continue to grow and evolve in the future — maybe not with their involvement but with people who have been loyal and dedicated employees for many years.
After the owner’s objectives are determined, an adviser must understand the company’s resources before recommending a certain type of deal structure. Specifically, consideration should be given to how the company is doing financially, how the industry in which the company operates is performing, whether there is a good business plan for continuing to grow and if the company has a good management team.
Once the owner’s objectives are determined and the company’s resources are analyzed, an adviser can determine whether an ESOP will be a good strategic alternative for the sale of the company.
Why are ESOPs an effective way to facilitate ownership transition in the current economy?
Sales of companies that do not involve an ESOP are generally all-or-nothing deals, in which a third-party purchaser acquires 100 percent of the assets or stock of the company, the founder goes away and a new management group assumes control. In a deal using an ESOP, the owner instead is dealing with a friendly group of employees who are willing to facilitate this transaction on a timetable acceptable to the business owner.
Currently, company valuations are down because of challenging economic conditions, so business owners might not want to sell the entire company right now. By using an ESOP, the owner can sell less than 100 percent of the stock of the company to get started with an ownership succession process and take some of the chips off the table.
Then, when the economy improves and valuations rebound, the owner can do another transaction with the company’s ESOP to get the benefit of a higher value.
In addition, the availability of outside financing for a transaction is currently very limited. Most third-party buyers of companies need a loan to fund all or a portion of the purchase of a business. However, banks are tightening their lending and credit standards such that financing is not readily available to fund the purchase of a company.
ESOP deals can be structured so that owners can sell their company and take a note back from the company — essentially, self-finance the deal instead of taking cash for their stock, which would require a bank to provide the financing. Because business owners who are willing to consider selling to an ESOP have a high degree of trust that their employees will be effective in running the business after the transaction, the seller is more willing to take on the risk of being the creditor of the company after the sale.
How can establishing an ESOP help owners stay involved with the company?
When a business owner sells a company to a third party, the owner typically sticks around for only a few months to make sure the transition goes smoothly and then rides off into the sunset. In an ESOP transaction, there is a friendly group of buyers who are used to the former owner of the business being involved in the company’s operations.
In many cases, an ESOP transaction is contingent on the owner staying around to help facilitate the transition. It is also important to consider that when rank-and-file employees become owners of a company, they have to act differently, and it may take some time for employees to start acting like owners and taking more initiative and control over the operation of the business.
David B. Solomon is a partner with Levenfeld Pearlstein, LLC. Reach him at (312) 476-7525 or firstname.lastname@example.org.