As the U.S. population ages, many leaders are beginning to think about preparing their business for the next generation. The business can be sold to a third party, gifted to heirs, or sold to management or employees through an employee stock ownership plan (ESOP). While ESOPs are not the most widely used option — there are only about 10,000 throughout the U.S. — they can be very beneficial for both business leaders and employees.
“Employees benefit from the increasing value of the business because they’re partial owners,” says Brian Bornino, CBA, CFA, CPA/ABV, director of valuation services with GBQ Consulting LLC. “There’s a lot of uncertainty about how people will retire, with the lack of pensions and Social Security being questionable. So having control of your own retirement and owning part of the company where you work is good for employees.”
Smart Business spoke with Bornino about why an ESOP is a good option and how to determine if it’s right for your business.
Why is an ESOP a good option to consider?
There’s a strong desire to try to keep jobs local. When you sell the business to your employees, jobs are locally controlled, whereas a third-party buyer may move the jobs across state lines, to a different city or even a different country.
Owners who built their business also have a pride factor and want there to be a legacy for the business. They would prefer an option other than selling to a third party that will integrate their business into the third party’s business, in which case their life’s work goes away.
There are also many tax advantages to an ESOP. A handful of academic studies has shown that employee-owned companies tend to outperform those not owned by employees.
What are the tax advantages of forming an ESOP?
The most powerful tax advantage of an ESOP is the ability to create an income-tax-free entity. If the ESOP owns 100 percent of an S corporation, the tax liability arising from corporate income flows through to the shareholder, which is a tax-exempt trust. That’s a very powerful advantage for savvy management teams, as a business that doesn’t have any income tax liability can invest that savings — which is often about 40 percent — and redeploy those dollars to grow the business through acquisitions, investment in equipment, hiring new people or paying dividends. That’s where a lot of the incentive is for management. They’re trying to build and grow the company, so if you can take out the largest expense item on the company’s profit and loss statement, that’s a major motivator.
Another key tax advantage is tax-advantaged financing, as the principal payments on ESOP transaction debt can be structured to be tax deductible (whereas typically only interest on debt is deductible).
These tax advantages also benefit the selling shareholders. To the extent that the selling shareholder is the one financing the deal, these advantages often result in the shareholders geting repaid quicker because the company has more cash to repay them. It becomes a lower risk proposition for the selling shareholder.
How do you determine if an ESOP is the best option for your company?
It starts with defining your goals for the transition of the business. The typical options are the outright sale of the company to a third party, selling or gifting it to your heirs operating in the business, or selling it to management or employees through an ESOP. You have to decide which of those you want to pursue. If you don’t have heirs in the business, that obviously eliminates that option. The sale to a third party makes the most sense if the company doesn’t have adequate management to run on its own. There also may be a strategic buyer that could help you maximize the purchase price, which makes a third-party sale more attractive.
The decision of whether to pursue an ESOP starts with the selling shareholder. If there is a desire to preserve a company’s legacy by keeping it independent, as well as reward employees who helped build the business, then an ESOP is often an attractive option. Because employees don’t put up their own money to buy the shares, virtually all employees will likely be on board, as they’ll get the benefit of owning the business. Obviously there will be skeptics, but by and large, most employees will be excited about an ESOP.
You also need to convince management of an ESOP’s benefits. On occasion, management may prefer to buy the company without involving employees, but the economics of management buyouts are different and management often cannot compete against the ESOP option.
What types of companies are most favorable to an ESOP?
Employee-oriented companies are often the best candidates for an ESOP, such as service companies, engineering or architectural firms, consulting firms or other companies where employees are critical assets to the business. ESOPs also make sense from an employee morale standpoint because you’re trying to attract, retain and motivate highly skilled employees, and employee ownership is a way to do that.
It also works for more traditional manufacturing and distribution businesses. Many times they have an easier time financing the transaction because they have the equipment and assets to borrow against, compared with service businesses that have to raise money for the transaction. Any business with a strong team, consistent cash flow and an interest in rewarding, attracting and motivating employees is a great candidate for an ESOP.
Brian Bornino, CBA, CFA, CPA/ABV, is director of valuation services with GBQ Consulting LLC. Reach him at (614) 947-5212 or firstname.lastname@example.org.
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