As Baby Boomer entrepreneurs begin working on their exit strategies, they might consider selling their company to its employees using a form of retirement plan called an Employee Stock Ownership Plan (ESOP). The employees benefits because they can purchase the company using pre-tax dollars, and maintain control of the organization. The owner benefits because they can avoid paying tax on the sales proceeds.
In the 1980s and early 1990s ESOPs boomed as business owners sold minority interests in their company (at least 30%) to an ESOP for the purpose of diversifying their assets without paying capital gains on the growth in value of their shares. Sellers to ESOPs can reinvest their sales proceeds in securities of US operating companies without paying tax. The Sub S ESOP exit strategy allows business sellers to avoid tax in a similar with the end result of increased cash flow.
Defining the terms
An ESOP is a qualified retirement plan, similar to a profit-sharing plan, in which employees purchase shares of the employer’s stock. A Sub S Corp is a type of corporation that does not pay tax; instead the corporation passes its profits to shareholders, who then pay income tax on the profits. With the Sub-Chapter S ESOP exit strategy, the corporation passes its income to a qualified retirement plan that is exempt from paying tax. Because the earnings of the corporation are not subject to tax, the acquisition debt is paid from pre-tax dollars, giving employees an advantage as a potential buyer.
What size companies does this work for?
This strategy does not work for all companies. It works best for those that meet the following guidelines:
- Revenues over $1,000,000
- ESOP participant payroll of at least 25 employees and $250,000 (preferably greater than $500,000)
- Companies that are profitable and growing
- Companies in the top tax bracket
Also, the ESOP cannot pay more than the appraised fair market value of the company.
Is this a viable exit strategy for you?
To determine if the Sub S ESOP exit strategy is the right way to go, first seek out or rule out the possibility finding buyers who willing to pay more than fair market value for your business. (Some buyers foresee synergies from the acquisition such as the elimination of duplicate overhead or cross-selling opportunities, and may be willing to pay more than the appraised value). Next you should conduct a preliminary feasibility study and address the following questions:
- What is the appraised fair market value of the stock?
- Is there a management team in place to run the company in the long run?
- Should the benefit of stock ownership be distributed broadly among all employees or restricted to a few key managers? Or a combination of both?
- Can the company’s projected pre-tax cash flow support the acquisition debt and company operations/growth?
Preliminary feasibility studies are an inexpensive way to determine if the acquisition strategy is viable.
Assemble a team of experts
If the strategy is viable the seller should assemble an ESOP team consisting of:
- An experienced ESOP business appraiser
- ESOP counsel who is separate from the attorney who normally advises the business
- Accountant or CFO capable of projecting company financial operations with the transaction financing
- ESOP administrator
- ESOP trustee and or an independent fiduciary to negotiate on behalf of the ESOP
The actual implementation of the ESOP Sub S ESOP exit strategy is highly complex and best left to the above mentioned team. Usually one of the advisors plays the role of lead consultant and oversees the significant amount of documented due diligence. The costs of these services are usually comparable with a business broker commission.
Steps of the transaction
The transaction happens in five phases:
- A qualified outside appraiser determines the range of fair market value, and then the trustee of the ESOP negotiates terms with the seller within the range.
- The ESOP borrows money from a lender and uses the loan proceeds to buy the stock from the owner.
- The ESOP trust is the shareholder. The trustee acts on behalf of the employees.
- The employees make contributions to the ESOP every year (that is, they purchase company stock on a pretax basis for their retirement). These contributions are used to pay off the loan.
- As the loan is paid off, the ESOP releases shares of stock to the employee retirement plan accounts.
C Corps vs S Corps
There are tradeoffs between C Corporation ESOPs and S Corp ESOPs. Sellers of C Corporation shares to an ESOP can roll over the sales proceeds into a diversified portfolio without paying capital gains tax. This benefit is not available for sellers of S Corporation shares. (And it can be more difficult to use management incentives like stock options or equity like deferred compensation in a Sub S ESOP.) Thoughtful planning can allow a seller to capture both benefits. For example, first sell C Corporation shares to the ESOP and then convert to Sub S status.
Both business owners and employees can take advantage of a company sale and the future growth of the company using the ESOP exit strategy.
Mickey Maier is a Vistage member and a Senior Consultant and Accredited Investment Fiduciary with Alpha Investment Consulting Group LLC. Over the last 20 years he has been involved in almost 100 ESOPs. He co-authored the 401(k) Answer Book and theParticipant Directed Investment Answer Book.