How Do Owners Make Use of an ESOP? Another Example
An ESOP is a very flexible thing. It can be applied in lots of ways, for lots of purposes. The only thing that will always be true is that stock of the sponsoring company will end up in the retirement accounts of the company’s employees.
One of the great things about an ESOP is that it provides a way for an owner to sell just some of his company. Most buyers – private equity firms, large players in the same industry, or others – want to buy the whole enchilada. After all, there are few things more powerless than a minority shareholder in a privately held company; and few investors want to go there. Not so the ESOP.
Take for example the case of a company founded by three buddies 18 years ago. They’ve been successful; the company has grown a start-up in one guy’s extra bedroom to an organization that, according to their CPA, is now worth $12 million on the market. But now comes a twist. One of the three wants out. He’s burned out, wants to be done, wants out. He tells the other two he’s entitled to $4 million for his third of the business. Their response? We agree, your piece is worth $4 million. And good luck with that “finding a buyer” thing. They point out, just in case Mr. Burnout hadn’t noticed, that the company doesn’t have $4 million lying around that he can take with him; nor are the two remaining owners in a position to buy him out as personal investments. And another thing: if Mr. Burnout could somehow find a buyer for his one-third interest, the other two would object. They don’t want some new guy coming in, no doubt with strange agenda of his own. So they’re stumped.
The solution – employed successfully many times now – can be an ESOP. If Mr. Burnout simply tendered his stock back to the company for redemption, that expenditure would not be a deductible cost of operation. Stock redemptions, after all, are conducted on an after-tax basis. That’s why there was no way the company could afford to simply redeem Mr. Burnout’s stock. But using an ESOP converts a redemption into a deductible, pre-tax expenditure. Depending on the applicable state income tax rate, the state and federal tax deduction generated by using an ESOP can add up to 40 percent or more of the actual redemption cost. At that rate, the repurchase of Mr. Burnout’s stock becomes feasible. The company will take out a bank loan for $4 million to buy the stock. They will then make annual payments of $800,000 plus interest to the bank over five years. With the special ESOP tax deduction, that lowers the net after-tax cost to $480,000 per year (plus interest). And with the newly purchased stock going to the employees, they can further offset the purchase cost by reducing their contributions to the 401k plan and limiting other compensation expenses. It suddenly becomes very doable.
But the two remaining partners are ultimately convinced to go this route when they realize that the stock will not go to some strange investor who wants to push his who-knows-what agenda. Rather, it will go to their employees, creating a powerful motivational program that they can leverage to boost company performance.
And when the second of the original partners decides it’s time for him to get out, the exit ramp will already be built.
Questions? Enter it as a comment to this post, and I’ll see about getting you a response.
Next week’s topic: ESOPs in Action: One More Example
Martin Staubus is with the Beyster Institute (part of the Rady School of Management at UC San Diego) where he advises company leaders on the effective deployment of ESOPs and other stock plans. The Institute was established by entrepreneur Bob Beyster, who grew his firm into a Fortune 500 company. https://www.rady.ucsd.edu/beyster/