The Latest on ESOPs: It’s Worth Knowing

So here’s the big question people want answered about ESOPs:  will an ESOP pay as much as other potential buyers?

Let’s back up a second and provide a little review: what’s an ESOP?

Technically, an Employee Stock Ownership Plan (ESOP) is a retirement plan, not unlike a 401k or retirement profit-sharing plan.  But there is more to it.  An ESOP is authorized to buy stock of the sponsoring company, and then holds it as retirement savings for the employees.  ESOPs can borrow money to finance their stock purchases.  So if you own stock in a private corporation, an ESOP means that you always have a way to sell that stock – whether just a few shares, a lot, or the whole interest.

Selling stock to an ESOP offers some remarkable advantages.  These include:

Big tax advantages.  A sale to an ESOP can produce the following tax savings:

• For the company.  The corporate cost to redeem stock is not tax-deductible.  But company funding for an ESOP is.  That’s a federal/state subsidy of up to 40%.
• For the seller.   A sale to an ESOP may be exempt from capital gains taxes.  With the new rates now effect, this may save you more than 33% of your proceeds.
• The employees.   Stock incentives awarded to employees are normally taxable income to them.  But the stock they get through an ESOP, is not.  This may save them 35% in federal/state taxes.

The ability to sell a portion of a company.  Most potential buyers want the whole company – all or nothing.  But you can sell an ESOP any portion of the company you want – the ESOP will buy whatever you care to sell.

No adversarial buyer across the table.  You get sole control over the deal.  Set up a sale when you want, in the amount you want.  Do what you want to do, not what an adversarial buyer is demanding, and deals don’t fall through. 

An opportunity to leave a legacy.  Selling to an ESOP means the company will continue on as a thriving, independent venture.  So the employees who have helped build the company will have the opportunity to keep it going.

But back to our question: what is an ESOP likely to pay for stock?  The answer is that an ESOP will pay the fair market value (on a financial investment basis) for any stock it buys, as determined by a professional appraiser hired by the company.  So, if another buyer is willing to offer a premium over FMV, the ESOP won’t be able to match.

But wait.  As noted, an owner selling to an ESOP can defer his capital gain taxes indefinitely, by reinvesting the proceeds in other investment securities.  On an after-tax basis, is a business owner still likely to do better taking a strategic buyer’s premium, or is the untaxed sale to an ESOP the better deal?

A study of this question was just released by a reputable investment banking firm using data from the 2012 FactSet Mergerstat/BVR Control Premium Study (“Mergerstat”).  It turns out that prior to this year in the majority of cases, sellers were likely to do better by taking a strategic buyer’s premium than by selling to an ESOP – even after factoring in the tax savings available.

But, as they say, that was so last year.  At the new 2013 rates, the pendulum has swung the other way.   In fact, of the 50 industries examined in the study, only eight saw sales premiums that would leave a seller better off after taxes than from selling to an ESOP.  In the other industries, sellers can now do as well or better selling to an ESOP.

An ESOP, then, is a serious option for almost any business owner who wants to liquidate some or all of his ownership.

Martin Staubus is with the Beyster Institute at UC San Diego, where he advises company leaders on ESOPs and other stock plans.  The Institute was established by entrepreneur Bob Beyster, who founded SAIC, a Fortune 500 company. 

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