As the owner of a private business, you are no doubt aware that, at some point, you will need to plan for an ownership transition. In reality, whether that date is quickly approaching or seems far off in the future, there is no better time to plan than now. Why? In order to make a successful ownership transition, several difficult, very personal decisions need to be made, including the following:
- What are your ultimate goals in life?
- What—and how much—do you need so that you are able to achieve those goals?
- Where do you see yourself in five years? 10 years?
- What does your company need in order to ensure a prosperous future?
- Where do you see your company in five years? 10 years?
- How can you prioritize your wants, needs and goals?
Next, you’ll need to consider the ownership transition options, each of which has its own financial and tax considerations as well as impacts on the employee base:
- Do nothing…let the business pass to your estate
- Sell to a strategic buyer
- Sell to private equity
- Sell to the company’s management team (a management buyout)
- Sell to an Employee Stock Ownership Plan (“ESOP”)
Ultimately, you will need to determine how these options overlap with your wants, needs and goals.
While the idea of selling to a third-party is usually a familiar option to most business owners, the concept of selling to an ESOP may not be. An ESOP is a liquidity strategy through which owners can sell either 100% or a fractional share of their company to a trust for the benefit of the company’s employees. It is a more controllable, friendly process than a third-party sale, as it allows for both continuity of the corporate culture and continuation of the owner’s legacy.
At its core, the ESOP is a retirement plan that is protected, for your employees’ benefit, by regulations promulgated by the Employee Retirement Income Security Act. With the continuing success of the company, value within each ESOP account grows on a tax deferred basis with liquidity upon the employee’s retirement provided by the company’s repurchase of the employee’s ESOP shares. Notably, studies show that offering an ESOP can be a differentiator in both attracting and retaining employees.
In addition, the ESOP is unique in its tax-efficiency as its debt is repaid with pre-tax dollars. In fact, the 100% ESOP-owned S-corporation pays no taxes. Also, under certain criteria, capital gains taxes to the selling shareholders may be deferred indefinitely.
What Makes a Company a Good Candidate for an ESOP?
Should you find the idea of an ESOP to be consistent with your goals, consider whether your business makes a good candidate for an ESOP. Strong ESOPs are typically defined by:
- A Company That Is Profitable and Growing – The ESOP should not be seen as a fix for a financially-challenged company. While the ESOP does offer tax and employee benefits to a company, these are only meaningfully realized as the company generates a profit. That said, a mature company with low growth and strong, predictable earnings can be an ideal ESOP candidate, while at the same time representing an unattractive option for private equity or strategic buyers.
- A Strong Management Team – With the formation of an ESOP, the existing management team—oftentimes including the selling shareholders—typically remains in place. Therefore, it is important to consider the depth of the management team and the management succession plan as you consider whether an ESOP is right for your company. It is important to note that the ESOP trustee will not want to manage the company and will be dependent on the management team to guide the company and implement ongoing strategies for success.
- A Solid Operating Model – Go-to-market strategy, market position, barriers to entry, competitive strengths, customer base, product or service differentiation, efficiency in production and product mix; all of these factors produce defendable, sustainable cash flows and lend support to the good ESOP candidate.
- The Desire to Maintain Independence – With an ESOP, a business owners’ concerns about business locations being shuttered or re-located, or “duplicative” employees being laid off, as may be the case with a strategic or private equity buyer, are all but eliminated. Contrary to the threat of lost jobs, the employees who have been instrumental in building the business will typically share in its success through an enhanced ESOP retirement benefit package. The legacy that you and your employees have created will live on without disruption within the business or the community.
- A Company Looking for a Tax-Favored Exit – As alluded to previously, an ESOP offers the potential for significant corporate and personal tax savings. For example, in the event that a C-corporation ESOP owns 30% or more of a company, the selling shareholder may indefinitely defer capital gains taxes on the transaction through what is known as a 1042 election. In the C-corporation, corporate tax reduction is affected by the addition of the ESOP’s non-cash benefits expense. Meanwhile, in the case of the S-corporation ESOP, corporate taxes are eliminated to the extent of ESOP ownership since the pass-through shareholder, the ESOP, is a non-taxed entity. Therefore, a 100% S-corporation ESOP company (and its owner, the ESOP trust) pays no federal income tax, and—in many cases—no state income tax.
- A Company With Adequate Debt Capacity – The ESOP is a tax-advantaged, leveraged transaction. Therefore, your post-closing capital structure will likely reflect a full level of bank debt; as a result, your company’s capacity to service debt is critical. The balance of transaction funding will commonly come in the form of subordinated seller notes. With the assistance of ESOP-related tax savings, we typically recommend that you aim to have all bank and seller financing for a 100% ESOP transaction repaid over a seven- to 10-year time horizon. Partial ESOP transactions may also be financed wholly with bank debt, with a shorter anticipated pay-back period. In either case, adequate debt capacity is a factor in support of the feasibility of the ESOP transaction.
The Feasibility Analysis
If you believe an ESOP may be the right option to satisfy your personal and business needs for ownership transition, once the business owner and management team are ready, the first concrete step to take is to conduct a feasibility analysis. A feasibility analysis is an evaluation of numerous aspects of your business, and it is an introduction to the ESOP transaction process so that you get a better understanding of what your company’s ESOP would look like and whether it would satisfy the goals and objectives you have established. Once the feasibility analysis is complete, if you determine that an ESOP is not the right ownership transition option for your organization, other transition options can be explored.
As part of the ESOP feasibility analysis, Prairie will meet with you to conduct in-depth due diligence and to confirm that we have a clear understanding of your ESOP transaction objectives. After that, we will:
- Solidify valuation expectations
- Test various transaction structures
- Analyze post-transaction effects on the company
- Conduct scenario testing and structure changes as necessary
- Identify and address any structural issues
- Identify likely transaction financing and the cash to be received by the seller
- Illustrate the anticipated terms of seller financing
- Discuss ESOP employee benefit profile
- Determine whether the proposed structure “works” for all constituencies: the seller, the company and the employees
Once the feasibility analysis is complete, if you decide to move forward, Prairie would be happy to work with you on the transaction strategy, process initiation, managing the transaction process and negotiations, and executing the ESOP transaction. As a nationally recognized advisor to owners of companies considering an ESOP exit strategy, we understand that the sale of your company is a once-in-a-lifetime event, and we are able to offer you comprehensive guidance to help you achieve your goals.
Richard Shuma is a Managing Director at Prairie Capital Advisors, Inc. He can be contacted at 630.413.5598 or by email: rshuma@prairiecap.com.
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