The Benefits of an ESOP Transaction for the Seller and Company

When Legacy Is More Important Than Profit, Consider an ESOP

Many owners of closely-held companies look at their business as their baby—something they’ve built, nurtured and grown through their own sweat and tears. These business owners are not looking for the highest price and are interested in ensuring their company continues to grow with the help of dedicated and loyal employees. For this type of business owner, utilizing an ESOP (Employee Stock Ownership Plan) is a good way for them to pass on their company to trusted employees. Employees acquire an ownership interest (shares) in the company, which creates a financial interest to increase the company’s value and continue growth. A successful ESOP transaction can be good for the buyer, the seller and the company.

Advantages of an ESOP

A sale of a company that does not involve an ESOP transaction is an “all-or-nothing” deal. In this type of transaction, a third-party purchaser acquires 100% of the assets or stock of the company, the new management group assumes control of the company and, in most cases, the prior business owner ceases to be employed with the company. This can happen immediately or within several months after the deal closes.

On the other hand, in an ESOP transaction, the new business owner is dealing with a friendly group of employees who are used to the former owner of the business being involved in the company’s operations. Typically, the buyer will be willing to facilitate this transaction on a timetable acceptable to the former business owner.

By using an ESOP, less than 100% of the business can be sold to begin the ownership succession process, thus taking some of the “chips off the table.” At retirement, the former business owner can perform another transaction with the company’s ESOP to sell any remaining equity. Thus, an ESOP transaction is very attractive to an owner who is not yet ready to retire and still wishes to be involved in the operations of the business—but needs some liquidity.

Compared with traditional exit strategies, ESOP transactions have more flexible financing structures. If necessary, ESOP transactions can be structured without any outside financing at closing. In situations when a shareholder is selling an amount of stock that is valued more than what a bank will lend, the selling shareholder can finance the transaction by issuing a seller note, which is referred to as a “leveraged ESOP.” The terms of the seller note are negotiated to represent prevailing market conditions as if the company obtained financing from an outside third party.

Benefits for the Seller

Perhaps the most unique benefit of establishing an ESOP to purchase the selling shareholder’s stock is that the seller may be able to permanently defer all capital gains taxes on the transaction if the shareholder’s stock is held in a C-corporation.

If the seller’s company is not operated as a C-corporation, the company can be converted into a C-corporation prior to the transaction to permit the current owners of the firm to take advantage of the tax deferral opportunity. So, compared to other sale alternatives, the ESOP transaction is a tax-efficient structure for the selling shareholder.

Benefits for the Company

An ESOP can reduce or even eliminate a company’s corporate tax burden. Additionally, since annual contributions to the ESOP are a fully tax-deductible expense, an ESOP company can fund both the principal and the interest payments on an ESOP’s debt service with pre-tax dollars. Generally annual contributions are limited to 25% of total qualified payroll.

While the annual contributions to the ESOP are tax deductible for all companies, there is a significant tax benefit when an ESOP owns 100% of the common stock of an S-corporation. Income from an S-corporation is passed to the shareholders of the entity. But since an ESOP is a qualified retirement plan that is exempt from all federal and most state income taxes, the benefit creates significant savings.

The 100% ESOP-owned S-corporation has a significant competitive advantage. They can use the enhanced cash flow from tax savings to be more cost competitive on bids, accelerate debt repayment, expand through acquisitions and attract new talent. While it is important to consult with advisors on the legal limitations related to establishing and maintaining 100% ESOP S-corporation status, the long-term benefits can lead to tangible increases in company value which translate directly into material retirement savings for employees.

Employee-Owned Companies Turn a Better Profit

In addition to the flexible deal structure and tax savings, numerous empirical studies have shown that employee-owned companies have been more profitable over the past few years. The benefits of having a well-incentivized workforce and an employee-ownership culture can help the company attract and retain well-qualified employees, which allows it to gain and maintain an advantage over its competitors. This can translate into a significant return on investment for the employee-owners in order to fund their retirement.

In times of crisis, such as the COVID-19 pandemic, employee-owned companies were able to cushion the financial blow better than non-employee-owned companies. According to a study by John Zogby Strategies, fewer than 1 in 20 ESOP employees reported job loss or downsizing compared to a shocking 1 in 3 non-ESOP employees. ESOP employees also reported less strain on their retirement savings, employee benefits and their ability to make rent.

Disadvantages of ESOPs

While this article focuses on the advantages of an ESOP transaction, there are certainly disadvantages:

1. An ESOP is a qualified plan governed by the Employee Retirement Income Securities Act (ERISA). As a practical matter, this adds a layer of expense and complexity that is simply not present in other companies.
2. The buyer will not be a strategic buyer. So, the seller is less likely to receive as large of a purchase price.
3. Sellers often have to finance part of the purchase price since employees typically do not have the cash necessary to contribute to the sale price.

Are ESOP Transactions Good for Employees?

There are many pros and cons to considering ESOPs but, as an employee, you need to know if this is a good option for you. Not only will an ESOP yield higher rates of return than a 401(k), they’re also more stable. Employee-owned companies lay off fewer people and plans cover more diverse employee demographics, such as younger or lower-income workers.

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[Editors’ Note: To learn more about this and related topics, you may want to attend the following webinars: ESOPs 101 and Protecting Your Employee Assets: The Life Cycle of the Employment Relationship. This is an updated version of an article originally published on April 16, 2019.]

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