When to Consider an ESOP
Business owners should consider an Employee Stock Ownership Plan (ESOP) when their management team is capable of running the business without the selling shareholders (or can adeptly replace the owner/manager) and the company doesn’t face imminent distress.
After a company’s sale to an ESOP and the eventual retirement (exit) of majority shareholders, the management team usually operates the business. In many cases, members of management may also be the ESOP’s trustee. In either case, management is running the business as if they purchased the company. If current management is not capable of running the business without the departing shareholders, then suitable management replacements must be found or the Company and ESOP risk failure.
EdgePoint often describes ESOPs as a “tax-advantaged management buyout.” Because management runs the business, and are often the highest paid, they have a larger share of ESOP share allocations. As owners, management benefits from their own success—this can be an effective motivator for the team. Tax advantages ranging from deduction of principal on ESOP formation debt to the complete elimination of income tax for 100 percent ESOP owned S-Corps create a tailwind for these transactions, helping ensure success as management assumes control of the business. There are plenty of other nonfinancial reasons to consider an ESOP, but the tax benefits can be compelling.
Other parameters to consider include the size and health of the company, the age of its workforce, and its debt capacity. Almost any size company can afford an ESOP, contrary to the common “minimum-size” myth. Costs to administer an ESOP are very similar to those of a 401(k), and most companies can afford the third-party administrator (TPA) that manages the 401(k)’s retirement trust accounts. The primary difference with an ESOP is that every year the company must secure a certified valuation of the shares to determine their value to participants and establish the buyout price for new share offerings or terminations/retirement redemptions. Valuations can cost from $5,000 to $25,000 for most companies per year, which is usually not prohibitive. Outside trustees, bank financing, attorneys and consultants are additional and often optional costs, but the primary annual ESOP administration costs are the TPA and annual valuation.
Workforce age matters merely because of repurchase-liability planning, but is not necessarily prohibitive. If a workforce is mostly older, the Company faces repurchase obligations earlier. This may trigger a liquidity need. However, flexible options exist that can be built into the ESOP plan, such as deferring repurchase payments while the ESOP formation debt is serviced, delaying the start of payments to participants and regulating the stream of those payments. Additionally, if an older workforce starts to retire within a few years after ESOP formation, not all of the stock will be allocated by then, and the company has had less time to grow its valuation. This slows share redemption, and redemptions are for less value than if the shares had been there longer.
Debt capacity is important to a new ESOP for two primary reasons. First, because no “equity” is infused by shareholders to purchase the shares, debt is the only funding source. Second, debt is used for liquidity to operate the business and eventually repurchase shares from ESOP participants. If the Company has limited borrowing ability, it makes ESOP a less viable alternative. Alternatively, the benefits to financing an ESOP is that higher tax advantages allow lenders to lend more money into an ESOP due to the business’ higher cash flow, and personal guarantees are generally not necessary. Certain government loan programs and mezzanine lenders have special lending rules that promote financing ESOP transactions.
If you are contemplating transition, and your management team is capable of running the business, regardless of whether you think they “have the money” to buy you out, contact us. We have financed management teams for both management buyouts (MBOs) and ESOPs with little or no equity.