October 2018 eNewsletter
Ownership Transition: Why Business Owners Should Consider an ESOP When Exiting Their Business
Kevin Ward, Senior Vice President, Huntington
Every privately held company, whether owned by individuals, a family or private equity, must go through ownership transition at some point. When the time comes, an owner has several options including: create liquidity via a leverage recapitalization using a debt-funded dividend to owners; sell control to a strategic or financial buyer; or sell a minority or majority stake of the company to an Employee Stock Ownership Plan (ESOP).
An ESOP is a qualified retirement plan designed to give employees an opportunity to receive the beneficial interest of employer stock and is the only retirement plan allowed to borrow money to purchase employer stock. Once purchased, the employer stock is allocated to accounts for individual participants so that, when they retire, they can either receive cash or shares, which are then sold back to the ESOP.
As a Qualified Defined Contribution Retirement Plan that is invested primarily in company stock, an ESOP is a flexible tool for owners to sell all or part of a privately held business. In this arrangement, the business owner controls the timing and extent of his or her exit and may still manage the company.
What are the characteristics of companies that are typically found to use ESOPs successfully?
ESOP plans work well for companies with:
- Strong cash flow
- A history of stable sales and profits
- Taxable income
- A capable management team in place and that will remain after the sale
- An annual payroll of $1 million or more
- An owner who has a significant portion of his or her net worth invested in the value of the business
- Valuable employees
Industries considered suitable for ESOPs include:
- Manufacturing
- Financial Services
- Professional Services
- Wholesale Trade and Distribution
What advantages does transferring ownership to an ESOP offer?
Selling to an ESOP is a tax advantaged transfer of ownership. There are income and estate tax savings for sellers, management and the company. For example, the capital gain from the seller’s proceeds can potentially be tax-deferred via Section 1042 rollover. Further, if the business is structured as a 100 percent ESOP-owned S-Corp., the company will not pay federal income tax. Also, an ESOP can deduct the transaction price over time, enhancing cash flow and improving credit metrics.
Another advantage to a seller when transferring ownership to an ESOP is liquidity — the seller gets more money after tax for the sale of closely held stock than for the sale of assets to a third party. The seller enjoys a rate of return via the seller notes, which is likely superior to any return available on an alternative investment with fully understood risk and within the seller’s control to manage. Selling to an ESOP offers flexibility as an owner may sell between 30 to 100 percent of the shares either all at once or gradually over time to accommodate multiple seller exit scenarios. It also creates the option for the seller to maintain management control over the company. Warrants and stock appreciation rights may be used to provide incentives to key managers.
How does the transition to an ESOP affect the employees who remain at the company?
There are indications that transitioning to an ESOP improves employee performance as a result of having an ownership interest in company and the accompanying enhanced retirement benefits. ESOPs can provide advantages to owners transitioning out of their companies, as well as employees. For the right companies, it can be worthwhile to explore an ESOP option.
This publication has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, general, tax, legal or accounting advice. Please consult with your own tax, legal and accounting advisors before engaging in any transaction. Huntington makes no representation or warranty, express or implied, with respect to the content, and accepts no liability arising from any use or reliance on this publication.
Retaining Talent Through Retirement Plans and Deferred Compensation
Dean Johns, CPA, John D. Dovich & Associates
With unemployment at historic lows, business owners are faced with significant challenges while trying to attract the talent that will allow them to continue growing their business. However, retaining key talent is even more critical to avoid the disruption caused by having to replace key talent. There are many strategies around retention involving culture, workplace environment, challenging work, etc. We will explore how the utilization of retirement and deferred compensation plans may provide the right financial incentives to retain your key talent.
A high-quality 401(k) plan is the most basic retirement plan that a company must have in today’s environment. Surprisingly enough, many companies still don’t have a basic safe harbor plan to allow its highly compensated employees (i.e.: key talent) the opportunity to maximize their annual deferral contribution limits. We often see plans that fail non-discrimination testing, which results in excess contributions being returned to key talent, and key talent not having the opportunity to contribute the maximum limits to a retirement plan. The plan should also have reasonable fees, as well as a diversified menu of high-quality investment options. If your key talent can’t achieve their long-term financial goals through the most basic of retirement plans with you, they will likely find another employer that will allow them to do so.
Again, with the idea of retaining key talent, owners should also consider utilizing the profit-sharing component to the 401(k) plan that is tied to the goals and objectives of the company. Oftentimes, businesses simply share their profits via cash bonuses. Obviously, a bonus is a nice immediate reward but is it the most tax-efficient way to reward your employees? And does it provide an incentive to stay on board via a vesting schedule? Many of the key talent will be “highly compensated” under the retirement plan definition/rules which allows for flexibility and discretion with regards to how you reward your key talent, as profit sharing allocations do not always have to be uniform if the plan is designed properly and assuming the key talent qualify as highly compensated individuals.
With the idea of providing the opportunity for even more qualified plan contributions you might consider a defined benefit plan (i.e.: a cash balance plan). Many individuals believe that so-called “pension plans” are a thing of the past. While many of the large company pension plans have been frozen or terminated, for small private or family-owned businesses, defined benefit plans can be very powerful and extremely tax-efficient. It is important though to have the right retirement plan consultant and actuary structure the plans appropriately based on the goals and objectives of the owner(s), all the while making sure it is harmonious with the existing 401(k)/profit sharing plan.
All of the plans mentioned above are qualified ERISA plans. Each of them has their own set of complex rules that must be followed to achieve tax efficiencies while providing for creditor protection of the plan assets. Another type of “retirement” plan to consider is a non-qualified plan. One such variation is a deferred compensation arrangement. These plans can be tailored to your key talent individually such that they are directly impacted by metrics relative to their role and/or goals, as well as the goals of the company.
Additionally, vesting schedules are oftentimes applied to deferred compensation plans to provide a financial incentive for key talent to stay on board, which is obviously a goal of the owner(s). We do find that for these plans to be successful though, the amount earned each year through deferred compensation must be meaningful – typically at least 25 percent of the key talent’s annual compensation. Otherwise, your key talent won’t see enough value in the plan to resist an offer to move elsewhere.
We also recommend that these plans be funded, as opposed to the benefits “accruing.” The benefits must feel “real” to your key talent or the key talent will not recognize the value a deferred compensation plan can and will bring to them. You should also consider your key talent having a say in how the funded assets are invested. Again, it helps for the key talent to feel as though the deferred compensation is theirs even during a vesting period.
Finding talent is hard enough. Once the talent is on board, focus your efforts on utilizing various retirement plans to provide the financial incentives necessary to retain it.
John D. Dovich & Associates is a Federally Registered Investment Adviser. Registration as an investment adviser does not imply a certain level of skill or training. The oral and written communications of an adviser provide you with information about which you determine to hire or retain an adviser.
Written Exit Plans Provide a Variety of Benefits for Business Owners
Crystal Faulkner, CPA & Tom Cooney, CPA, Partners, MCM CPAs & Advisors
When you are first beginning the process, planning a business exit can seem overwhelming. There are many steps in the exit planning process, including building business value, developing capable successors and planning exactly what you want to do after you leave. In our experience, designing a successful exit isn’t something that business owners can tackle alone if they want to depart on their terms. So, where should you start?
We recommend beginning with the basics. Write it down. Committing your exit plan to writing can provide several benefits when done properly.
Increase clarity and chance for success
Written communication can force clarity and specificity that verbal communications often does not. Typically, the act of writing causes business owners to think carefully, minimizing chances for misinterpretation. This can cut down immensely on the amount of time it takes to implement the plan by months or even years.
Written exit plans encourage accountability. In a written plan, all participating advisors have responsibilities and deadlines which makes it an executable document. It also helps you avoid procrastination. Too often we see business owners develop a strategy only to have it sit in their offices with no execution or timeline. Having a document that tracks deadlines and responsibilities can keep you accountable and help you avoid falling prey to the “rolling five-year plan,” wherein you’re always looking to exit five years from now.
Finally, simply writing your goals down increases the likelihood that you’ll achieve them. According to studies on goal setting, written plans are much likelier to be executed. Dr. Gail Matthews, a psychology professor at Dominican University in California, found that individuals are 42% more likely to achieve their goals just by writing them down.
Maintain control
A common exit planning paradox is that most business owners don’t want to give up control of their companies before they’re ready, but they also don’t want to spend too much time on exit planning. Having a written plan gives owners a chance to maintain control of the process while also controlling when and how they transition out of ownership.
Owners who write their plans down—typically aided by an advisor—can easily hand the plan over to a team of advising professionals who help in its execution. This means that once you’ve confirmed your goals and written them down, your team of advisors can get to work addressing the issues and generate results. Formalizing your exit goals can increase your planning efficiency and give you the time to continue to build your company’s value.
Minimize cost and time
In general, creating an exit plan can take several months, while executing it can take several years. This usually requires input from owners and several advisors including your attorney, CPA, insurance professional, banker, estate attorney and financial advisor. Exit planning should also involve an owner’s family and management team. With so many moving parts, it’s easy for owners to use more time and money to exit than necessary. A written exit plan helps mitigate these burdens.
Written exit plans can make the process more time- and cost-effective because they allow you to see where everyone is in the plan. Rather than wasting hours calling each advisor to ask what they’re doing—time that you could be spending working to generate company revenue—a written plan allows you to track everyone’s progress. Your exit planning advisor acts as the team quarterback and is responsible for keeping the document current and making sure that it reflects the resources, goals and assets relevant to your exit. When your advisors are all on the same page, knowing what they must do and when, it usually minimizes the time and money you’ll need to spend on the process itself.
Written exit plans can benefit you as you begin to plan your business exit, and it’s important to remember that “written down” does not mean “chiseled in stone.” They can, and often do, change. As your business and goals evolve, a written plan gives your planning strategies a chance to evolve in lockstep. We highly recommend working with an exit plan advisor to get your own exit plan down on paper to ensure the exit process is moving forward efficiently and in the right direction.