For the owners of closely held businesses considering ownership transition, the number of ownership transition options available may not be known. Options can include a sale to a third party, a management buyout (MBO), transition to family, or an Employee Stock Ownership Plan (ESOP). For many business owners, an ESOP can be an attractive alternative due to its numerous benefits. A host of
factors will influence which option is best for each owner’s unique situation, but for those seriously considering an ESOP, it is important to begin with a basic understanding of the pros and cons of an ESOP.
What Is An ESOP?
An ESOP is a qualified employee benefit plan that provides an internal transition of ownership with financial rewards for the business owner and the employees. An ESOP trust is established to purchase stock from selling shareholders. The ESOP may borrow money to facilitate the purchase, which can be repaid by contributions the ESOP receives from the company. Shares of stock are then allocated to employee accounts based on their compensation levels. As long as an employee remains an employee of the company he/she will become increasingly vested in his/her account. An ESOP can help to ensure the continuation of the business, which is important to many owners who have worked so hard for so many years to grow their businesses.
The Pros
An ESOP is scalable over time and offers a great degree of flexibility and advantages, a number of which follow.
- For a business owner, an ESOP allows for a greater deal of internal control over the transaction and can take less time to implement when compared to an external sale.
- With an ESOP, the business owner can decide if he/she wants to sell all ownership or instead transition ownership gradually over time. Utilization of an ESOP to create liquidity for a minority stake does not preclude an owner from selling the company to a third party in the future.
- ESOPs can help business owners gradually begin the process of converting their closely held ownership over to liquid, diversified capital.
- An ESOP is an ideal way to vest employees in the company and boost morale. The opportunity to share in company growth and performance gives employees a sense of ownership, with the potential to invigorate their contribution to the success of the business.
- Finally, there are a number of attractive tax and investment benefits with an ESOP. The loan used to finance the ESOP transaction is effectively repaid by the company with pre‐tax dollars. In the case of a C‐Corp, a selling shareholder can indefinitely defer capital gains taxes associated with the sale of his/her shares. And for S‐Corps, the ESOP’s share of recognized earnings is tax exempt.
The Cons
Although there are numerous benefits to an ESOP, they do require understanding of a unique combination of fields such as valuation, business transaction dynamics, tax law, regulatory compliance under ERISA and more. After all, the company is supporting a leveraged buy‐out of its shareholders. The perceived complexity of an ESOP can prove to be a detractor when deciding whether or not to implement an ESOP. Other detractors can include the following:
- Current shareholders are unlikely to maximize proceeds from a sale to an ESOP. The ESOP is a financial buyer, not a strategic buyer.
- One hundred percent cash at closing is an unlikely scenario in today’s lending environment and seller financing is common.
- An ESOP requires ongoing administrative costs, including annual valuation, plan administration and trustee fees.
Proper Guidance Is Key
While an ESOP can seem complicated and present unique challenges, ESOPs can be a highly effective tool for ownership transition with a host of advantages for business owners. Most often, the tax, financial and cultural advantages far outweigh the effort of implementation. The best advice for any business owner is to consult a trusted ESOP expert like Prairie Capital Advisors, Inc. With a thorough understanding of all of the ESOP pros and cons, business owners can gain the understanding of how an ESOP will affect their ownership transition plans so they can make an informed, confident decision they can be happy with now and for the long term.