Is an ESOP Right for Your Business?August 08, 2016
All privately held businesses deal with succession planning at some point, but the tax and employee benefits offered by ESOPs make them an option that you may wish to consider seriously—here's why.
Eric S. Zaiman, Executive Director
ESOP Advisory Group, J.P. Morgan
Every company has a natural lifecycle, and at some point, all privately held businesses must transition company ownership, either to a family member, to management or to an outside entity. This is not just to create liquidity for the owner but to select the company’s future form of ownership.
In cases where the owner's family won't be taking control, companies have several options for transition, including an initial public offering (IPO), a sale to a strategic buyer or private equity firm, or a leveraged recapitalization. For owners seeking another avenue—perhaps because they wish to continue to lead or otherwise remain involved with their companies, or they wish to have their companies remain independent—one strategy is an employee stock ownership plan (ESOP).
What Is an ESOP?
An ESOP is a qualified retirement plan. It's designed primarily to invest in the sponsoring company’s stock to provide its employees with ownership of the company and a retirement benefit. The ESOP is funded by the employer with tax-deductible contributions, either in the form of company stock or via cash, which is used to purchase company stock. ESOPs are unique in their ability to borrow funds to buy larger blocks of stock, which can be repaid via company contributions.
To determine whether an ESOP is the right solution for your company’s ownership transition, it's important to weigh the benefits an ESOP yields, as well as the potential challenges it raises.
Benefits to the Seller and the Workforce
One attractive aspect of an ESOP is that it delivers financial rewards to the company, the owner and the company's workforce, facilitated by tax benefits.
For the seller, an ESOP transaction means the ability to reap the profit from having built value in the company over many years and gain liquidity to diversify wealth or buy luxury assets.
For employees, it means the ability to share financially in the company’s success by receiving beneficial ownership of company stock.
The tax code presently affords sellers with the potential to defer capital gains tax while giving the company tax deductions of the transaction price over time, thus enhancing cash flow and improving credit metrics.
What's more, ESOPs are tax exempt and pay no tax on their pro-rata share of company earnings. As a result, 100 percent ESOP-owned S Corporations essentially pay no federal income taxes and in most cases no state income taxes.
In addition to these financial benefits for sellers, an ESOP can also ease concerns an owner may have around a strategic sale or a sale to a private equity (PE) firm—in these types of sales, it's always a possibility that the new owner or company will leverage the business and break apart its operational components purely for profit, disrupting the business and potentially threatening the job security of its workforce. An ESOP can be a great option for owners focused on preserving the business and supporting the employees after ownership transition.
An ESOP is also an effective way of motivating and rewarding employees for their contribution to the company’s success. Employees build ownership that can grow over time to provide them with substantial wealth upon retirement.
A Typical ESOP Story
While ESOPs come in all shapes, sizes and situations, the following is a fairly typical story:
Three founding shareholders built up a good business over more than 20 years. When they reached their early to mid 50s, they all began to see the need for liquidity to help with net worth diversification. Additionally, two shareholders had a strong desire to make substantial charitable gifts. One option they considered was selling to a private equity firm, as they had a fair amount of interest and had even started to elicit offers. However, they wanted to give their employees the opportunity to share in the long-term success of the company, so they ultimately decided that such a transaction wouldn't necessarily be good for their employees. They ended up selling the company to a newly formed ESOP for a good price, which was financed with bank debt and seller notes. Since then, the company has been quite successful, which allowed it to repay most of the transaction debt after only a few years. Today, the company is looking forward and is seeking out growth opportunities to appropriately expand its business and build value.
Formation and implementation of an ESOP demands a series of rigorous activities, including:
- Conducting feasibility and alternatives analyses
- Forming advisory teams
- Managing investor due diligence
- Securing financing agreements
- Managing documentation and closing
Understanding and following the best practices for each of these activities is essential for smooth ownership transition via an ESOP. At the same time, businesses that pursue ESOPs will encounter potential challenges through increased leverage and incremental IRS and Department of Labor regulations. Additionally, ESOP companies are required to fund ESOP repurchase obligation, a requirement of the Internal Revenue Code that guarantees a “put option” on participant shares, giving participants the right to force the company to repurchase shares at the latest fair market value. Effectively managing repurchase liability requires careful planning and expert guidance.
It's never too soon to begin thinking about and preparing for ownership transition. Through planning and strategic partnerships with industry experts, owners can determine the best strategy for their businesses and their employees—and if that strategy includes significant tax and employee benefits, an ESOP could be the right ownership-transition strategy for your company.
Eric S. Zaiman is an Executive Director of J.P. Morgan’s ESOP Advisory Group.
The information herein does not purport to set forth all applicable issues and is not intended to constitute advice on legal, tax, investment, accounting, regulatory or any other matters. J.P. Morgan makes no representations as to such matters or any other effects of any transaction and shall have no responsibility or liability to you with respect thereto. You should consult with your own advisors regarding such matters and the suitability, permissibility and effect of any transaction. In no event shall J.P. Morgan nor any of its directors, officers, employees or agents be liable for any use of, for any decision made or action taken in reliance upon, or for any inaccuracies or errors in, or omissions from, the information herein.