Business owners who decide to sell their company to an employee stock ownership plan (ESOP) often say they do so not just for the significant tax advantages, but to preserve their legacy.
“They really want the business to survive them, especially if their name is on the door,” says Jim Altman, Middle Market Pennsylvania Regional Executive at Huntington Bank.
In many instances, owners sell to an ESOP to reward long-term employees who helped the owner create value in the company and generate wealth. Owners know they can’t run the business forever and want to take care of their employees. An ESOP provides an avenue to do that.
Smart Business spoke with Altman about the process and benefits and reasons to sell a company to an ESOP.
What are the direct benefits to a business owner and employees of selling to an ESOP?
In selling to an ESOP, owners will get, by definition, a full and fair price for their business. There are also tax advantages — an owner may defer all the capital gains tax on the sale of their business until they pass.
Owners are also able to realize an attractive return on their seller notes. In many ESOP transactions, about one-third is financed by a bank and two-thirds is financed by the seller. The seller notes may carry a premium rate that can generate 10 to 12 percent interest.
Employees, however, are the true winners in an ESOP. They receive a retirement benefit that is more significant than they’d get through any other program.
Who does an owner need to involve when selling to an ESOP?
There are many professionals involved in an ESOP transaction. The process is essentially as follows: The seller hires an ESOP financial adviser, which is like an investment banker, to quarterback the process for the owner and determine the company’s value. The owner also hires ESOP counsel, preferably an ESOP expert, to set the terms of the ESOP to comply with ERISA law and to negotiate with the legal representative for the buyer. Once an owner has legal counsel and a financial adviser, then it’s time to select an ESOP trustee — the entity that will oversee the Employee Stock Ownership Trust, or ESOT, to buy the stock of the business. The trustee, once selected, hires its own ESOP legal counsel and ESOP valuation firm, and comes up with its own valuation of the business. The two sides then negotiate the price until the owner feels comfortable selling.
How does selling to an ESOP differ from selling to a strategic or financial buyer?
Selling to an ESOP is not dramatically different than selling to another buyer. The difference lies with the benefits to the seller, company and employees. With an ESOP, an owner may defer the capital gains tax on the sale. When the owner’s S-corp stock is sold to a trust, the company becomes exempt from federal and most state income taxes going forward.
There is some regulation when it comes to the sale price of the business. While the buyer, an ESOP trustee, and the seller are free to negotiate, the trustee is guided by ERISA laws and the U.S. Department of Labor in order to protect the employees from overpaying for the company. Each ESOP transaction is eventually reviewed by the DOL. If the DOL determines that the purchase price was excessive, it may reduce the price.
What are some reasons an ESOP wouldn’t be in the owner’s best interests?
If an owner doesn’t have a good management team in place to run the business after he or she steps away, a trustee will see that and won’t want to buy the business. Businesses that have cash flows that fluctuate wildly are less attractive and will get less value in an ESOP structure. Also, companies that are highly leveraged should pay off their debts before attempting a transaction. Otherwise the purchase price will go toward debt and not the owner.
ESOPs are misunderstood and not widely talked about, but offer business owners a tax-efficient way to benefit their employees and preserve their legacy in the community after they have left the business. While a sale to an ESOP may not be for everyone or every business, the strategy is one every business owner should consider as part of their ownership transition plans.
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