ESOPs
This month, we take a deeper look at a unique transaction structure:
the sale to an Employee Stock Ownership Plan (usually called an ESOP—no, not
the guy who wrote all of those fables).
As with any other succession strategy, ESOP sales are not
right for every business. But for the
right type of business, the ESOP sale offers a unique way to strengthen the
company’s culture while providing significant tax benefits.
A number of great companies have been very successful
operating as an ESOP, with the Publix grocery store chain often being cited as
the “gold standard” of successful ESOPs.
However, there are a number of stories of ESOPs that went bad, due in
many cases to a lack of planning and proper analysis on the front-end to ensure
that the ESOP would be successful.
I’m no expert on ESOPs.
So this month, I’ve asked the co-chair of our mergers +
acquisitions practice, who has significant experience with ESOP
transactions, to share his thoughts.
With that, let’s dive right in…
1. What is an ESOP?
An ESOP is simply a defined contribution retirement plan
that invests primarily in employer stock.
In some ways, it is similar to a 401(k) Plan. When an employer company launches an ESOP, it
forms a trust that purchases some or all of the employer company’s shares, and then
holds these shares in retirement accounts for its employees. Employees share in the employer company’s
success or failure through their participation in the ESOP plan. The company buys out employees’ accounts when
they retire or leave the company.
The ESOP is a qualified non-discriminatory retirement plan
governed by The Employer Retirement Income Security Act (ERISA) of 1974, and is
subject IRS and Department of Labor oversight.
There are tax benefits for having such a plan in place, but there are
also rules and regulations that must be followed. So, it is critically important to seek
professional advice if you’re considering an ESOP.
Unfortunately, ESOPs aren’t an option for every
company. Generally, only C or S
corporations may adopt an ESOP, and certain types of corporations (such as
those used for certain professional services businesses) are prohibited as
well. Another form of entity, such as a
limited liability company, would need to convert to a C corporation or to an S
corporation prior to adopting an ESOP.
2. How does a company transition to being ESOP-owned?
For most companies, an ESOP provides a succession
strategy. The owner(s) of the business
sell the stock of the company to an ESOP Trustee in much the same way that an
owner would sell stock to an independent third party buyer. However, because the buyer is a qualified
plan, there are some special differences and considerations, some of which are
described further below.
3. How is the purchase price determined?
In a typical third party sale, the purchase price is
whatever the buyer and seller agree upon.
With an ESOP sale, the same market forces don’t really exist because the
ESOP is not an independent third party that seeks to profit from the
transaction, nor does the ESOP typically have its own source of capital to fund
the transaction. Moreover, ERISA
prohibits an ESOP from paying more than “fair market value” for the stock. Consequently, an independent qualified
valuation expert performs a valuation of the business and issues a fairness
opinion to the ESOP Trustee to rely upon in negotiating “fair market value” for
the price and terms related to its purchase of the shares of the company.
4. How is the transaction financed?
In most cases, the ESOP transaction is financed through a
combination of existing company cash, a traditional bank loan to the company,
and seller-financing for the balance of the purchase price in the form of a
promissory note that is payable to the selling shareholder(s). The ESOP Trustee, on behalf of the ESOP, is
the actual purchaser of the stock, but the company is ultimately obligated to
repay both the bank loan and the seller notes (and provides the security for
these loans). The transactions required
to create this scenario result in an “internal loan” between the ESOP and the
company, and an “external loan” between the company and the lender(s).
5. What are the tax benefits of an ESOP?
ESOPs are popular for a number of reasons, but for many
companies, the unique tax benefits associated with ESOPs are a major motivator.
An ESOP offers a tax-efficient,
leveraged buy-out vehicle. ESOPs can
yield tax benefits to the company, to the selling shareholder(s) and to the company’s
employees.
While there are several tax benefits, two of the more compelling
tax benefits are as follows:
ESOP-owned
S corporations pay no federal income tax:
Yes, you read that right. S corporations themselves pay no federal
income tax because they are pass-through entities. Because the ESOP is a qualified, tax-exempt plan
for income tax purposes, it doesn’t pay income tax either. So the result is a massive potential tax
benefit for 100% ESOP-owned S corporations.
And, even if the ESOP owns only part of the stock of the corporation,
the percentage owned by the ESOP will be income tax free. For example, if the ESOP owns 50% of the S
corporation stock, the 50% owned by the ESOP is income tax free, and the
remaining 50% is taxed to its owners in the normal manner. Imagine what you could do if you could
legally avoid paying income taxes!
Owners of
C corporations can rollover sale proceeds in a tax-free manner:
If the
target company is taxed as a C corporation at the time of sale, the selling
shareholders could—provided they meet certain requirements and make an election
under Section 1042—rollover their proceeds from the sale into qualified replacement
investment property and defer payment of the capital gains taxes resulting from
the sale to the ESOP. If the seller
retains the qualified replacement property until death, the entire taxable gain
could end up being forgiven.
Note that these two benefits are available for different
types of corporations. However, if the
target corporation is a C corporation prior to the ESOP transaction and is
eligible to elect S corporation status after the transaction, both of these
powerful tax benefits could be achieved.
Even for corporations that can’t avail themselves of the benefits of
switching from C corporation to S corporation status, the tax benefits may
still be significant.
Of course, as with any tax issue, there are all kinds of
caveats, rules, and restrictions that apply.
A good advisor can help determine which tax benefits may be available
for your situation.
6. Who controls the company if an ESOP owns
the shares?
The ESOP is controlled by an ESOP trustee, which is usually
an independent corporate trustee that is experienced in these matters. That said, ESOP trustees don’t have the
interest or bandwidth to get involved in running the company’s operations
day-to-day. So, in most cases, the
existing board and management team remain in place after an ESOP transaction.
However, note that on certain major transactions, the
employees themselves will be able to vote the stock allocated to them through
the ESOP.
7. Do I have to sell all of the shares of my
company to the ESOP?
No, but as noted above, S corp ESOPs don’t get the full tax
benefit unless the ESOP owns all of the shares.
In addition, some of the other tax benefits require the ESOP to own at
least 30% of the shares. However, for
some types of companies, a 100% ESOP sale may not be possible, so it may still
be worth exploring whether an ESOP can make sense even in those cases.
8. Can I control which employees receive the
shares in an ESOP?
Generally no, other than restricting participation to
full-time employees. The company can
prescribe vesting criteria for the stock allocated to a participant, subject to
certain restrictions.
9. How and when do the employees receive
payment for the shares held in their ESOP?
When an employee leaves the ESOP company, he or she will get
paid for the vested stock held in his/her account. The payment for the stock is determined by a
third party appraisal which ESOP companies must obtain annually from an
independent professional valuation company.
10. What are the characteristics of companies
that are successful in selling to an ESOP?
ESOP-owned companies work best when there is a culture of
ownership among the employee base. ESOPs
can be powerful tools when all of the employees believe that their efforts to
contribute to the company’s growth will directly benefit them at
retirement. Certain employee groups can
grasp the concept and turn it into better results for the company. In contrast, certain employee groups don’t
really understand or value the benefit that ESOPs can provide.
In addition, ESOPs only work when the company generates
sufficient and steady cash flows to service the debt and to pay out employee
share repurchases. For those ESOPs that
are 100% owned by an S corporation, the cash flow issues are lessened to some
degree by the federal income tax savings.
But even for those companies, there may be difficulties in generating
the consistent cash flows needed to satisfy these obligations.
11. What are the downsides from selling to an
ESOP?
While the tax benefits noted above get all of the headlines,
the truth is that selling to an ESOP solely to reap the tax rewards is
generally a bad idea.
First, understand that ESOPs have substantial start-up costs
and significant continuing compliance obligations. Transitioning out of an ESOP can be costly
and painful as well. So the decision to
enter into an ESOP should not be taken lightly.
In addition, there are both legal and practical restrictions
on how much the ESOP can pay the selling shareholder(s) for the business. If you’re seeking top dollar for the company
or require receipt of 100% of the sales proceeds at closing, it’s possible that
you’ll have more success selling to a buyer in the open market.
Finally, employee ownership can sometimes change the
relationship between management and employees.
In some ways, this can be a positive dynamic. Employees in an ESOP will have more
information about the company’s financial health and will certainly have much
more concern for the company’s overall performance. However, employees who don’t have the full
picture may become disgruntled if they perceive the stock’s value as too low
due to mismanagement of the company, whether rightly or wrongly.
12. How do I determine if an ESOP is right for
my company?
The first step is to have a discussion with an experienced
ESOP advisor who can help you understand the pros and cons of
ESOP ownership for your business, particularly in light of your company’s
unique culture and the business owner’s goals.
The next step is to perform a deep-dive into the financials
(known as a feasibility analysis) to determine whether an ESOP is even
economically feasible given the cash requirements noted above.
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There’s obviously a lot more to ESOPs than what we can cover
here. The key takeaway: ESOPs don’t work
for every business, but depending on the company’s circumstances and the
owner’s goals, they could be a great solution to providing shareholders with an
exit, continuity and a platform for future growth.
Next month: Crisis Demands Creativity in M+A
Read last month’s
piece: Alternative Transaction Structures
