How Do Owners Make Use of an ESOP?
An ESOP is a very flexible thing. It can be applied in lots of way, 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.
Having said that, the most common scenario is where a business owner wants to wind down his involvement in the company and move toward retirement. Take the case of Jack Smith (a real case, but the name has been changed to protect this smart guy). Jack has owned a successful construction company in California for 25 years. He was wise enough to focus primarily on the construction of commercial buildings for local government, hospitals and colleges, so he didn’t get hammered by the crash in residential construction. In fact the company has stayed busy, maintaining revenue and profitability throughout the economic downturn.
A valuation by an independent professional business appraiser pegged the fair market value of the enterprise at $10 million. Jack’s ultimate plan? He decided that, this year, he would sell 50 percent of the company to an ESOP, for a price of $5 million.
Some decisions then had to be made:
- Would he arrange for a bank loan of $5 million to the ESOP, so the ESOP could pay him cash up front? If so, the company would then make periodic tax-deductible cash contributions to the ESOP so that the ESOP could pay back the loan over time. Or would he simply take a promissory note (IOU) from the ESOP, with the company then making the same periodic contributions to the ESOP so it could make its payments to Jack?
- Would he elect to defer payment of capital gains taxes on the $5 million he would be paid for his stock? To do that, he would need to get paid in full up front, meaning he would need to arrange for the bank loan. It would also mean that he would be unable to participate as an employee in the ESOP – something he could do if he did not elect to defer his capital gains taxes (it’s a pretty nice deal: get paid for all the stock you sell, then get some of those shares back, deposited in your own ESOP retirement account).
Jack ultimately decided to skip the bank loan (the fees, conditions, and collateral requirements were unattractive) and arrange to be paid about $1 million per year (plus interest) for the next five years. He also decided not to claim the optional tax deferral on his proceeds, since a) he would then lose out on accumulating shares in his own ESOP account; and b) with capital gains rates probably at an all-time low, better to bite that small bullet now than to end up paying higher rates down the road.
The rest of Jack’s plan? Five years from now, once he has been paid in full for the initial 50 percent that he sold, he will sell the remaining 50 percent, for an expected price of $7.5 million. Jack figures the company will easily be worth $15 million by then, given a) the recovering economy; and b) the expectation that the employees will be motivated by their co-ownership to push up the value of their equity.
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: Example #2
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 founded SAIC, a Fortune 500 company. https://www.rady.ucsd.edu/beyster/