By Thomas L. Totten, FSA, PhD - Founder, Stokastique
As companies plan for management succession and exiting owners, multiple options are available including:
Indiana has 26 employee-owned companies (ESOP) who are either contractors or in the construction industry. Let me offer you a short summary of ESOP’s and the advantages and disadvantages of selling to employees as an ESOP.
Selling your company through an ESOP is a lot less of a traditional method, but it can be very financially rewarding for both the current owner(s) and the new owners - your employees. How an ESOP pays out the company owner is by receiving money from an Employee Stock Ownership Plan (ESOP) through the sale of stock in exchange for cash or a stream of payments to the existing owner(s). The company can use funds that would normally go toward income tax liabilities to pay the owner. The company can also make tax-deductible cash contributions to the ESOP or arrange a bank loan for the ESOP to buy the owner's shares.
What is an ESOP?
An ESOP is essentially a retirement program (much like a 401(k)) that can hold the stock of a company. Annually, the company decides how much stock is allocated to employees that enter their “retirement plan.” Since it is a qualified retirement plan under IRS regulations, employees are not taxed on the stock and all stock appreciation is tax deferred until the employee leaves the company. At that time, the stock is converted to cash (as the company buys the stock back) and the employee can roll the money into an IRA thus avoiding taxation.
How is the company managed after the sale?
In many ways the company maintains its independence and is run the same way before the sale. The owner can still stay with the company and run the business, if that is their decision. ESOPs are most successful with a strong management team in place and a good succession plan - should the owner expect to leave the business. In addition, a formal board of directors must be created to meet the regulatory requirements of an ESOP, but the owner will essentially be able to select who sits on the board.
Are there other parties involved?
Since the company will be technically owned by a retirement trust (ESOP), a trustee will have to be named to safeguard the assets. Generally, this is a person or an institution and will not be involved in the general running of the company. This is where companies like Stokastique become a key partner.
What are the positives in selling to an ESOP?
The new owners of the company are the employees, and the management staff is traditionally the same as before the transaction. Therefore, the culture and running of the company will not change. An owner can still stay in the company and run it, and frankly it is important for that leader to be involved for a certain amount of time – a period that is up to the owner, board of directors, and the management team. The most important positive is that the employees now share in the success of the company.
What are the negatives in selling to an ESOP?
Any selling transaction will incur costs and the same will be to an ESOP. It is not a cheap endeavor as parties such as appraisers, trustees, and attorneys will need to be involved. In addition, the ESOP will offer a fair price for the business. The fair price may be less than another type of buyer, such as a competitor or private equity. Finally, it takes time to finalize the deal and that can be frustrating at times.
Conclusion
When planning for succession of the business, owners have several items to consider in this process. It is best if the owner knows what it really wants to accomplish in the transaction to help decide the best route for themselves. If you want to learn more, feel free to reach out to the Indiana PHCC offices and we will get you connected to the right people to discuss this exit strategy.
