Jay Sachetti joined Jeff O’Brien, partner at Husch Blackwell and Dyanne Ross-Hanson, president of Exit Planning Strategies talked about the market for mergers and acquisitions, exit planning opportunities for companies that don’t end up for sale and how companies can maximize their eventual sale price during an early October panel at the first Upsize on Tap event at Summit Brewing Co. in St. Paul.
When the state Legislature passed a law requiring employers to provide paid leave and safe time for employees, Justin Bieganek started hearing differing details from friends, colleagues and peers.
If you are the owner or co-owner of a business and are looking for a way to convert your ownership into cash proceeds, perhaps to fund retirement or to invest in something else, and you want to maintain the status quo, operationally and with current management and workforce, the answer is a qualified “yes.”
At a minimum, an employee stock ownership plan or ESOP should top the list of alternatives for your consideration.
The answer is “no,” however, if you are looking to obtain the highest possible price for the business and don’t much care whether the business continues in its current form, with current management and employees.
If you liked the qualified “yes” response, the rest of this article will help you assess whether you are ready to move forward with an ESOP professional and dig into the details of selling to an ESOP.
An ESOP is a qualified retirement plan, much like a 401(k) plan but without employee deferrals, that is designed to invest primarily in the stock of the business.
A trust established in connection with the ESOP actually owns the stock, which is allocated to employee accounts or held in suspense for future allocation. Stock may be either contributed or sold to the ESOP trust.
An ESOP has the unique ability (among retirement plans) to take out a loan to fund the purchase of stock, which means that it may purchase stock using cash borrowed from the company or the selling stockholder may accept a promissory note from the ESOP as consideration for the stock (oftentimes with a cash down payment).
Along with serving as a purchaser of stock, with or without leverage, an ESOP accomplishes several objectives:
It’s a business succession tool. An ESOP provides business owners a way to transfer ownership without the risks associated with “going to the market” with the business they founded and wish to continue, both as an employer and as a corporate citizen and taxpayer in the community in which they reside.
It provides equity incentives for employees. An ESOP is a tax preferred structure for providing employees with beneficial—not actual—ownership of their employer. Equity ownership can motivate employees to increase productivity and efficiency and give them a unique reason to stay with the employer. Research conducted by non-profits shows that ESOP companies are more profitable, have lower employee turnover and have recovered more quickly from the recent economic downturn.
It’s a retirement benefit for employees. As a qualified retirement plan, an ESOP provides an annual deduction to the company for contributions, tax-deferred benefits to employees available upon termination of employment, and tax-deferred earnings and value growth within a tax-exempt trust. A company on a steady growth path can provide significant retirement benefits to its employees with a smaller up-front investment. A 401(k) plan can and typically is offered as a supplement to the ESOP to give employees the ability to defer their own pay for retirement.
It provides tax benefits, and this is most significant. If the company is a C corporation, contributions and dividends to the ESOP trust, which may be used to repay ESOP debt, are deductible by the company. A selling shareholder may defer tax indefinitely on the sale of stock if certain requirements are met and may avoid tax altogether if the replacement property is transferred at death.
If the company is an S corporation, the company pays no tax as a pass-through entity and, to the extent of the ESOP trust’s ownership, net earnings passed through to it are tax-exempt.
This point cannot be overstated: Otherwise taxable profits earned by an S corporation that is wholly owned by an ESOP are not taxed at any level because an S corporation is a pass-through entity and the ESOP shareholder is a tax-exempt trust. Tax is paid only when the stock (or the cash value of the stock) is distributed to former employees after retirement, death, disability or other separation from service, just like any other retirement benefit. Former employees can further defer income tax liability by rolling the cash value to an IRA.
It is a closely held C or S corporation with an enterprise value of at least $5 million.
The company has a history of modest but steady profitability.
The management team is experienced, strong and trusted.
The company is not highly leveraged and has a good relationship with its lender.
The workforce is stable and payroll and benefits are competitive.
Company culture is open, cooperative and supportive.
Are there any downsides to an ESOP? An ESOP is more expensive to establish and maintain than a 401(k) plan, primarily because the stock owned by the trust must be appraised annually.
If stock is transferred to the ESOP trust in a leveraged stock purchase, transaction costs can be as high, and sometimes higher, than sales of stock to other types of buyers. Also, as noted at the outset, an ESOP will not be able to pay top dollar. The law restricts the ESOP to paying no more than “fair market value.”
Finally, eventually, the company will need to fund the repurchase of the stock in a gradual process as employees retire or otherwise leave employment.
First steps include retaining an ESOP consultant or ESOP attorney, obtaining a preliminary estimate of the value of the company and determining whether you will need bank financing to do the ESOP transaction. You will also need to give some thought to whether you want to retain a professional ESOP trustee or financial institution or whether you will appoint one or more individuals at the company to serve as trustee.
It is also a good time to do some corporate housecleaning like making sure the shareholders and board of directors are holding at least annual meetings, there is adequate directors and officers and fiduciary insurance and the shareholders are not using company accounts as personal piggybanks.
