The Basics of ESOPs

Building a successful company generally takes years of hard work and sacrifice. Transitioning ownership may often elicit strong emotions from a business owner whose identity is tied to the business: What will my legacy be? Will my employees be treated well? What role will I have after the sale?

Most owners believe that transitioning ownership means selling to a competitor or private equity. However, selling to an Employee Stock Ownership Plan (“ESOP”) can be a compelling alternative. Additional benefits of an ESOP include continuity of the owner’s legacy and corporate culture as well as attracting and retaining employees.

Q: What is an ESOP?

An ESOP is a qualified retirement plan regulated by ERISA and the Internal Revenue Code (“IRC”).

According to the National Center for Employee Ownership, there are approximately 6,200 ESOPs in the U.S. covering nearly 14.0 million participants.

Q: How does an ESOP work?

To form an ESOP, a trust is set up for the purpose of purchasing all or some of the company stock from the business owner and for the benefit of the company’s employees. An ESOP can pay up to, but not more than, fair market value for the stock. Once acquired, shares of stock are allocated to the eligible employees and vest over time.

ESOPs also provide unique tax advantages to both the business owner and the company. Typically, an ESOP is financed with a combination of bank and seller debt, and both principal and interest payments on the loans are tax deductible to the company. Additionally, ESOPs are tax exempt trusts. In the most optimal of circumstances, S corporations that are 100% ESOP-owned do not pay federal and, oftentimes, state income taxes.

In certain instances, sellers can defer paying capital gain taxes on the sale by making a §1042 election. In short, §1042 of the IRC allows sellers to indefinitely defer paying capital gains taxes when selling to an ESOP. To qualify for §1042, the company must be a C corporation at the time of sale.

Q: How do employees benefit?

Employees are not required to invest their own money in the ESOP. Shares owned by the ESOP Trust are allocated to participants on a nondiscriminatory basis and valued once per year by an independent appraiser. Participants accumulate shares over many years and are entitled to receive a distribution when they terminate employment. Similar to other qualified retirement plans, participants pay taxes on their ESOP proceeds when they take distributions beyond the age of 59 ½.

Q: What type of company makes a good ESOP candidate?

ESOP companies come in all shapes and sizes. However, good ESOP candidates typically have the following characteristics:

· Strong management team

· Solid operating model (profitable and growing)

· Healthy balance sheet (ability to assume debt)

· Highly engaged workforce

· Desire to remain independent

Q: What is there to know about exploring an ESOP?

There are two primary phases involved in establishing an ESOP. The first is the valuation and feasibility phase which involves an advisor analyzing and modeling various scenarios that may meet the owner’s objectives. This initial phase typically takes six to eight weeks.

The second phase is the transaction execution phase and involves hiring professionals for the seller, the company and the ESOP trustee and includes raising capital, ESOP trustee and bank due diligence, negotiations and documentation. This phase also involves hiring professionals for the seller, the company and the ESOP trustee. Just like in any commercial transaction, each party to an ESOP transaction has their own independent team of advisors. This phase typically takes three to six months, depending on the overall complexity of the transaction.

Q: Where should you start?

If you think an ESOP might be right for you, start by talking to an experienced ESOP advisor. For over 25 years, Prairie has been educating and advising business owners on ESOP exit strategies. Please contact us if you would like to learn more.

Rocky Fiore is a Managing Director and COO at Prairie Capital Advisors, Inc. He can be contacted at 630.413.5575 or by email: rfiore@prairiecap.com.

‍Download the full article above.

Connect With
Prairie Capital Advisors

Subscribe to Our
Resources & Insights