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:
- 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.