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 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 an excellent way 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 company’s assets or stock, a 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 business’s former owner 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.

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 business’s operations but needs some liquidity.

Compared with traditional exit strategies, ESOP transactions have more flexible financing structures. ESOP transactions can be structured without outside financing at closing if necessary. When a shareholder is selling an amount of stock 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 can permanently defer all capital gains taxes on the transaction if the shareholder’s stock is held in a C-corporation.

Suppose the seller’s company is not operated as a C-corporation. In that case, the company can be converted to a C-corp before the transaction. This will let the owners defer taxes. 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 the 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. However, since an ESOP is a qualified retirement plan exempt from all federal and state income taxes, the benefit creates significant savings.

The 100% ESOP-owned S-corporation has a significant competitive advantage.

They can use the tax savings’ higher cash flow to:

• Compete better on bids.
• Pay off debt faster.
• Expand through acquisitions.
• Attract new talent.

While it is essential 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

Many studies show that employee-owned firms are more profitable. This is in addition to the flexible deal structure and tax savings. A well-incentivized, employee-owned workforce can attract and keep top talent. This gives the company a competitive edge. This can translate into a significant return on investment for the employee-owners to fund their retirement.

In times of crisis, such as the COVID-19 pandemic, employee-owned companies could 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 ability to make rent.

Disadvantages of ESOPs

While this article focuses on the advantages of an ESOP transaction, there are certain 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 a purchase price.
3. Sellers often have to finance part of the purchase price since employees typically need more cash 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. An ESOP will yield higher rates of return than a 401(k), and 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.

We think you’ll also like:

1. Steps for Protecting Business Sale Confidentiality
2. The Purchase Agreement Essentials: Representations and Warranties
3. How Do I Evaluate Multiple Offers in a Business Sale?

[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can listen to at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

1. Keys to a Successful Sales Process
2. Advertising Aces: Maximizing Reach and ROI
3. Turning an Idea or Product Into a Business

This article was originally published in April 2019 and updated on August 3, 2021. This article was most recently updated by the Financial Poise Editors.] 

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