ESOPs: a 40-year-old succession strategy attracts new interest
Company, owner and employees all enjoy a wide range of financial benefits.
In 2017, the owner of Engineering Economics, a 78-employee firm in Golden, Colorado, was pondering his retirement options. Selling to a buyer that might terminate some of the workers or eventually spin the company off wasn’t appealing. He asked the company managers if they wanted to purchase the firm, but they lacked the equity and risk tolerance.
“He wanted to reward the employees who had built the company, but, like most entrepreneurs, he also wanted his own personal reward—a fair price for the company,” says Blake Hickok, Engineering Economics’ chief financial officer.
The solution was a four-decades-old approach to succession-planning that is attracting more attention: employee stock ownership plans or ESOPs.
Created in 1974, an ESOP is a tax-qualified retirement plan that provides a company’s workforce with ownership interest in the firm. A trust fund is set up for the employees, and the owner sells stock in the company to the trust. The sale is financed through tax-advantaged bank loans and seller debt.1
“ESOPs and employee ownership are proven methods of succession planning that benefit not only the owner, but also the company and employees,” says Doug Dell, director of middle market specialty finance for KeyBank.
Over the next decade, an estimated 2.4 million Baby Boomers will transition their businesses—“the single largest transfer of business ownership in our nation’s history,” says James J. Bonham, president and CEO of the ESOP Association.
As this “silver tsunami” begins, a number of cities and states have been promoting ESOPs as a way to preserve local jobs. “We are on the brink of an explosion of awareness of ESOPs similar to what we saw with 401(k) retirement plans in the late ’80s and early ’90s,” Bonham says.
Taking Chips Off the Table
ESOPs offer owners a number of advantages, such as the ability to sell minority positions and enhance their return by participating in the growth of the company after its sale.
“One of the attractive features of an ESOP is that an owner could take some chips off the table, diversify their wealth away from their business by selling a minority ownership and still have control of their company,” Dell says.
ESOPs, which provide a structure for determining fair market value of a privately held firm, can address many of the issues that come with selling a business outright to family, competitors, private equity or strategic buyers. With an ESOP, owners do not have to expose their financial information, customer list or intellectual property to competitors in the sale process. The chances of an employee exodus—which can occur if they learn of a sale-in-progress to an outside entity—are greatly reduced.
Owners can also maintain their standing in the community by keeping their business open and in the same location. “Business owners who use ESOPs often invoke the word legacy,” Bonham says. “After they sell their business, they want to continue to participate in the community, knowing they have preserved the jobs of the people who grew their company.”
Closing the Wealth Gap
A number of studies have shown that ESOPs are more profitable, pay higher wages and are less likely to lay off employees than their conventional counterparts. With ESOPs, employees are motivated by being owners to maximize their production. Employee-owned firms also have an edge in attracting and retaining talent.
“ESOPs allow working-class Americans to gain ownership in the company and to build wealth outside of their day-to-day paycheck,” Dell says. “I’m passionate about ESOPs because they provide a way to close the wealth gap.”
The ESOP has paid off for Engineering Economics. “Our culture is our secret sauce, and the ESOP allowed us to preserve it,” Hickok says. “After the sale, the owner remained the company president at first and then became the chairman. No positions were eliminated.” And the company has thrived: Since the ESOP was put in place, the company’s share price has increased 35% annually.
Dell points out that an ESOP typically provides significant financial and tax benefits for both the owner and employees.2 Generally:
- A selling shareholder can defer and ultimately eliminate capital gains taxes on the sale of C Corp shares to an ESOP.
- ESOP financing is tax-advantaged. Generally, principal and interest payments on ESOP debt are tax deductible, subject to limitations.
- If an S Corp is 100% owned by an ESOP trust, no distributions are required to pay the owners’ tax bill; the ESOP trust is tax-exempt.
- Acquisitions by an ESOP-owned company can be structured to allow target company sellers to defer capital gains, potentially lowering the acquisition price.
- Employees are not taxed on annual contributions or appreciation until they take a distribution, which they can roll over to an Individual Retirement Account (IRA) to defer taxes.
- At age 55 and after 10 years of employment, participants are allowed to diversify a portion of their company stock holdings into traditional marketable investments, such as mutual funds.
The steps to establish an ESOP can seem complicated. “Business owners must navigate the complex regulatory environment, as well as weigh the benefits and drawbacks of receiving proceeds in an ESOP transaction versus a straight sale to a private equity or strategic buyer,” Dell says. “Yet, the upside of an ESOP can be very attractive for sellers who are ready to exit their business, but want to see it continue with the employees who made it successful.”