Hidden Advantages of ESOPs As Alternative Succession Strategy

December 20, 2013Articles New York Law Journal

Reprinted with permission from the December 20 issue of New York Law Journal. (c) 2013 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.

The next 10 to 15 years will pose some daunting and unique challenges for closely held business owners and their advisors, as it's no secret that baby boomers will be retiring in large numbers.

With fewer and fewer children following their parents into the family business that may have been in the family for generations, a sale to either a strategic or financial (but in either case unrelated) buyer often seems to be the only viable alternative. With the demographic trend already well underway, sellers of family-owned firms may be surprised to discover that there may be relatively few and selective buyers interested in acquiring what have for decades been cash-generating and family-employing, although often niche or old-economy, businesses.

As a result of these generational trends, employee stock ownership plans (ESOPs) are increasingly being considered, among the "arrows in the quiver" of possible exit strategy options, to be explored by closely held business owners aiming for retirement.

Sale to a Trust

In concept, a sale of a closely held business to an ESOP is relatively simple. Instead of the owner selling his or her business to a third party, a business owner sells the business to a trust (i.e., the ESOP), established and operated by the business, for the benefit of its employees. To finance the trust's purchase of the business, the ESOP borrows from a bank, other financial institution or a private equity mezzanine lender. Alternatively, the business owner himself or herself may act as the lender for the ESOP's purchase of the business.

In most respects, the ESOP operates just like a 401(k) or profit-sharing plan, except that it invests primarily in employer stock. The stock of the business, formerly owned by the entrepreneur and purchased by the ESOP, serves as collateral for the loan (in addition to other collateral as may be required by the lender). On an annual basis, and as the business continues to operate, it makes tax-deductible contributions to the ESOP until the loan has been repaid.

As previously noted, the ESOP is a trust, managed by trustees and operated for the benefit of the employees of the business. With few exceptions, ESOP participation must be extended to all full-time non-union employees of the business. Just as, in the typical lifetime or testamentary trust, the trust has legal title to the employer securities and other assets, and the trust beneficiaries have no direct interest in trust assets. Accordingly, with few exceptions it is the ESOP's trustees who exercise all of the rights accorded to shareholders of the company. The employees participating in the ESOP have no direct ownership interest in the shares, and, therefore, are not entitled to access to the privately held company's financial statements and other information regarding its finances, contracts and business dealings.

Similarly, since it is the ESOP, and not its participating employees, which has the status of shareholder of record of the company, the ESOP participants have no vote or other direct voice in the company's day-to-day business decisions. In fact, it is common for existing management, including the business' owner, to remain in operational control of the business after a sale of all or part of the company to an ESOP. In one of the more common scenarios, the sale to the ESOP is effectuated in a series of stages, over a period of several years. In that manner, a business owner is able to gradually relinquish control of his or her business, and therefore more gradually turn over the reins of the business to the new management team he or she, if desired, has had an opportunity to select, mentor, evaluate and train.

Tax Advantages

Among the principal advantages of ESOPs are the substantial tax incentives afforded to owners who sell their companies to ESOPs, and companies that operate as ESOPs. Pursuant to Section 1042 of the Internal Revenue Code (IRC), the owner of a business who transfers his or her stock to an ESOP can avoid the payment of the capital gains tax that would normally be incurred upon the sale or other disposition of the business. In addition, under Section 404 of the IRC, both principal and interest on the loan, incurred by the ESOP to purchase the company's shares of stock from the owner, is repaid with pretax dollars (although subject to certain limitations that generally limits the benefit to 25 percent of the business' payroll).

Perhaps the most powerful advantage of an ESOP is its ability to operate as a tax-exempt entity. Once the ESOP owns 100 percent of the stock in the company, the ESOP can cause the company to elect Subchapter S status. As a Subchapter S corporation the business can pass-through its profits to its sole shareholder, the tax-exempt ESOP, thereby for all intents and purposes enabling the business enterprise to operate as a tax-free company. The usual requirement that a profit-making business owned by a tax-exempt organization pay tax on the income derived from the profit-making portion of the business pursuant to Section 512 of the code, does not apply to ESOP-owned companies.

Practical Advantages

When business owners are evaluating the exit strategies available to them, there are additional advantages to ESOPs that make them well worth exploring. Third-party purchasers usually demand complete control of the acquired business from day one, although financial buyers may require the seller to remain with the business after a sale for some transition period. With an ESOP, a business owner can choose to sell all or only some portion of his or her stock to an ESOP in the transaction. This is a big advantage to owners who want to remain involved with the operation of the company for some period of time, while still taking some "chips off the table" at such time or times as he or she desires.

Along a similar vein, while the sale to an ESOP must be handled as an arm's-length transaction, based upon a third-party valuation of the business, as a practical matter, the sale is much less disruptive than a sale to a third party. While the ESOP cannot pay more than fair market value for the business, based upon an independent valuation conducted by the ESOP's trustee, in the typical situation, even before the ESOP has been established, the business owner will have conducted his or her own "back of the envelope" valuation of the business. As long as the ESOP trustee's offer to purchase the business is within the seller's price expectations, it is highly likely that an ESOP transaction will take place.

The typical problems that may cause a non-ESOP business purchase and sale transaction to fall through, such as buyer's remorse due to reversals in the economy, concerns raised due to issues uncovered during due diligence or the purchaser's inability to obtain financing, may delay, but typically will not derail, an ESOP-buyout transaction. Any prospective seller of a business who has endured the disruption occurring during a buyer's due diligence, only to have the deal fall apart at the 11th hour, will appreciate the advantage of a transaction where the chances of closing are much higher.

In addition, there is much less disruption of the business operations when an ESOP is the buyer. While the ESOP trustee will conduct the due diligence required of an arms-length transaction, there is nevertheless an understanding that existing management will remain in place, and know where all the bodies are buried. Accordingly most trustees do not require the level of due diligence often conducted by many strategic or financial unrelated third-party buyers.

Therein lies another practical advantage of ESOPs over other exit strategy transactions. With an ESOP, the seller has much greater control over the timing of the transaction. The ESOP trustee is not distracted by competing transactions, the vagaries of the global financial markets, approvals from third-party boards of directors or other urgent corporate business. In many cases, an independent trustee is engaged to represent the ESOP with the singular marching orders of purchasing some or all of the shares of stock of the target company and, therefore, is more likely to remain focused on that goal until the transaction is closed.

Successful ESOP Candidates

Despite all of these advantages, ESOPs are not the answer for every business or every situation. So, one may ask, specifically when should an ESOP be considered?

As a threshold matter it should be noted that only corporate stock can be sold to an ESOP, so businesses operating as LLCs or partnerships must first be converted to a corporation. However, in most cases the conversion is an inexpensive, tax-free conversion under Section 351 of the Code.

While corporations of any size may establish an ESOP, the costs involved generally discourage companies from doing so when they have less than $1 million of earnings before interest, taxes, depreciation, and amortization (EBITDA). Because profitability is one of the main drivers of value, it is important that the business has been profitable in recent years and/or has strong prospects for achieving and maintaining profitability in the near future. Businesses with predictable levels of profitability, as opposed to those with dramatic swings in earnings, more easily lend themselves to an ESOP transaction. Cash flows should be sufficient to enable the company to repay the debt incurred for purchasing the stock from the business owner.

Organizations with owners who have higher levels of loyalty to their employees tend to be better candidates for an ESOP. Therefore, by way of example, a business owner whose sole objective is to obtain the highest price for his or her business, such as from a strategic buyer, with full knowledge that the buyer may well lay off 25 percent of the workforce within six months of the closing, is not an ideal ESOP candidate.

Although an ESOP can be a powerful incentive to the business' employees, the employees will need to be educated to be able to appreciate how their increased productivity during their working career for the company translates into a higher share price of the enterprise, resulting in a greater retirement benefit for them. This kind of incentive typically lends itself to a more sophisticated, well-educated or professional workforce, but this is by no means a universal rule. Successful ESOPs have been sponsored by restaurants, contractors, airlines and manufacturers. It's all about taking the time and effort to educate the workforce.

Another important ingredient for a successful ESOP candidate is a company with a deep management team, with the potential for junior managers to grow into senior management positions, and operate the business upon the retirement of the owner and senior managers. In smaller organizations, it is generally sufficient that there be two or three individuals in the pipeline. As buyers continue to become increasingly selective, ESOPs will become more and more competitive with third-party buyers.

In light of the greater flexibility accorded to sellers in ESOP transactions, powerful tax benefits and a greater degree of certainty that a closing will occur, ESOPs are a valuable tool that should be seriously considered as an alternative buyer by most closely held business owners.

Reprinted with permission from the December 20 issue of New York Law Journal. (c) 2013 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.