Business owners looking to exit are often faced with the following dilemma: cashing out at a reasonable price is very important, but they don’t want their business swallowed up by a large industry player eliminating the identity of the business they have built. They are concerned that their employees are treated fairly as well. Business owners in this situation often weigh the benefits of a sale to an Employee Stock Ownership Plan (ESOP) versus a sale to an outside buyer.

An ESOP is a very specialized type of IRS sanctioned qualified retirement plan. It is the only retirement plan that is permitted to own a concentrated amount of stock in its corporate sponsor. ESOPs have been specially designed so that employees can effectively own stock in their employer. The federal legislation establishing ESOPs was specifically designed to encourage employee ownership. When you read in the business press about “employee owned companies” they are probably talking about ESOPs.

ESOPs hold great attraction to business owners looking to sell. In order to encourage the development of ESOPs, Congress established some terrific tax benefits for owners selling their business. Most importantly, a business owner can sell her company to an ESOP and elect to defer all federal tax on the sale. To do this, the owner is required to invest the sales proceeds in a portfolio of publicly traded stocks and bonds of U.S. companies. Also, since an ESOP is a tax-exempt organization, if the company is an S Corporation, to the extent the ESOP owns the shares, the company is not subject to tax on its income.

Let’s consider a real life example (with the names changed). Jones Manufacturing produces a medium technology product that it sells to the military, pharmaceuticals, and oil and gas industries. Its non-military customers are Fortune 1000 companies. The company owns intellectual property in the form of industry certifications for quality and effectiveness of its products that are highly sought after and difficult to obtain. Sales are about $15 MM and EBITDA (Earnings before Interest, Tax, Depreciation & Amortization) is about $2MM. The company has 55 employees including 11 engineers and others with a high level of technical proficiency. It has received a purchase offer from a large competitor of $14MM with 90% of the cash at closing with the rest (subject to certain contingencies) payable within 18 months.

The owner has built this company from modest beginnings over 20 years with the help of a core group of key employees who have been with the company for more than 10 years. In particular, the company has a general manager who is capable of running the business and works with most of the key customers. Another key employee runs the service department which is very profitable and important for customer retention. The owner emphatically wants to see the employees benefit from any sale transaction. However, the prospective buyer is likely to move the research and development operations to its main facility about 200 miles away while maintaining a production and assembly line at the current location (for now).

A sale to the prospective buyer will result in substantial cash at closing. What would an ESOP transaction look like?

A sale to an ESOP need not be for 100% of the stock—while 100% transactions are possible, more typically a portion of the stock is sold initially, perhaps 30%–50%. One of the attractive features of an ESOP sale is that the owner can maintain control of the company as portions of the stock are sold. The sale is usually financed by a bank loan and the debt capacity of the company is a limiting factor in the amount of stock that can be sold at any one time. Jones Manufacturing’s ESOP consultant thought that a loan of about $5MM was the maximum feasible borrowing. Therefore, either the owner would be able to sell only about 36% of the stock ($5mm divided by $14MM total value) or the remaining stock would be sold via seller financing—the business owner would take back a 10-year note for about $9MM. I have seen several ESOP transactions where 30%–40% of the stock was sold initially, the bank loan was paid off over a period of 3–5 years, then another 30%–40% of the stock was sold. Alternatively, the owner could choose to sell only a portion of the company to an ESOP and retain the remaining stock personally. The problem with either the seller financing or the serial stock sales is that the owner is tied to the company for a long period of time—say 7–10 years. While there might be upside potential if the company grows in value, there is also risk in waiting for 10 years to be fully paid off. This is the major dividing point between owners who do a traditional M&A sale to a third-party versus a sale to an ESOP—are they willing to retain substantial ownership risk for an extended period of time? (Please note that we have greatly simplified all aspects of the ESOP transaction to give the reader a broad overview.)

A complicating factor is that a sale of 50% or less of the company stock will result in a minority interest discount to the value of the stock purchased by the ESOP. This discount might range from 10%–20%. There are ways around this—one is to convert some of the stock to preferred and sell the preferred stock which is entitled to a premium because of dividend and liquidation preferences. Another technique to enhance returns to the seller who takes back a note for a portion of the sale price is to attach warrants to the note which effectively gives the note holder an “equity kicker” down the road. These are examples of the type of complexity that might be part of an ESOP transaction.

As noted, the sale to the ESOP is financed with a bank loan. The bank loan is repaid by the ESOP by receiving tax deductible contributions by the company to the ESOP retirement plan. Like other retirement plans, the employer contribution is limited to 15% of payroll. In our case, payroll is about $4MM, so the annual plan contribution is limited to $600,000. This is one limit on the size of the bank loan. But there is an important tax benefit because in effect the interest and principal of the loan are being paid with tax deductible contributions to the ESOP. This is the only instance that I am aware of that a business can get a tax deduction for repaying loan principal—another important tax benefit of the ESOP.

In an ESOP, the employees are the beneficial owners of the shares but not the legal owners. The shares are owned by the retirement plan and the plan in turn is managed by a fiduciary/trustee. Since the employees don’t own the shares directly, they are not entitled to receive financial statements and don’t vote on corporate actions that require shareholder approval. Employees are entitled to receive the cash value of their allocated percentage of ESOP value when they retire.

ESOPs are highly regulated—they must follow tax regulations as well as rules promulgated by the Department of Labor. DOL requires ESOPs to get an independent business valuation every year.

So who is a good candidate for an ESOP? There is a certain size threshold because of the administrative complexity and attendant administrative cost—an ESOP candidate should have a minimum of $1MM in EBITDA and $1MM in payroll. The company needs a strong management team and low debt (so it has the required borrowing capacity). The owner typically has a strong commitment to maintain the independence of the company and wants to preserve the current workforce. The business owner can control the pace of the sale and “take some chips off the table” while maintaining control.

An ESOP probably won’t work for a seller who wants to make a quick exit—say in 2 years. That seller needs a buyer who will pay cash at closing.

ESOPs are very popular in certain industries. For example, the Engineering News Record reports that 40% of the top 500 engineering and architecture firms in the country are at least partly owned by an ESOP. Across all industries, ESOPs today include over 13.7 million employee-participants with over $923 billion in assets.

Sales to an ESOP and sales to a third-party are both complex transactions and require advisors well versed in these transactions. Don’t try either of these by yourself. One must hire an ESOP specialist to plan an ESOP transaction.

In the right circumstances, an ESOP can be a home run for a business owner—tax benefits, maintaining control, financial benefits to employees, and the business advantages of giving employees a financial stake in the success of the company. However, many business owners will find that cashing out at closing is the preferred option.

Published in Business2Business magazine, May 2016