While not the most common form of company ownership, Employee Stock Ownership Plan (ESOP)s have found a niche. According to the National Center for Employee Ownership, as of 2021, there were approximately 6,533 ESOPs in the U.S., holding total assets of over $2.1 trillion. Some of the more recognizable ESOPs include the grocery chain Publix Super Markets and craft brewer New Belgium Brewing Company. How did they become ESOPs?
The Basics: Under an ESOP, the company sets up an ESOP trust to hold shares of the company. This trust is regulated by the Department of Labor and can be thought of as a retirement plan like a 401(k). The ESOP holds company shares in trust as an investment for the ESOP participants’ benefit, and the cash for this investment can come from the company directly or through bank or seller loans.
The Selling Price of the Practice: Under federal law, an ESOP can only pay fair market value for your business, and this fair market value must be determined by an independent appraiser. If the ESOP approach is right for you and the appraisal feels reasonable, the ESOP trust buys your shares at the price determined by the independent appraiser. Please note competitors, known in the industry as strategic buyers, might be motivated to pay for more than fair market value because of the synergies they project through market control, cost-cutting, and similar measures. If you stand to make considerably more money by selling to a third party, it’s certainly worth considering the other pros and cons of selling to a strategic buyer.
Taxes: Many third-party sales may be treated as a combination of ordinary income and capital gain. ESOP transactions, on the other hand, are taxed as capital gain. Certain ESOP transactions will allow the seller to defer and potentially eliminate the capital gains taxes through a 1042 exchange. Additionally, because ESOPs are designed to direct profits into an ESOP trust for the benefit of its employees, and these contributions are tax-deductible, ESOPs can be structured to pay little to no corporate tax moving forward.
How You Will be Paid: An outside bidder tends to offer a larger up-front payment and make the remaining payments over a short period. On the other hand, ESOPs often pay a smaller up-front payment and a note payable over several years.
Impact on Your Employees and Your Business: Considering a sale to an outside company means that any potential bidder will have access to your financial statements and other confidential documents. So, if you decide not to sell to one or more competitors, they may now have detailed information about your business. Next, suppose an outside company is an eventual buyer. In that case, they could decide to place their own people in key positions and lay off several current employees. And for the employees who remain, there are other potential problems. On the other hand, since an ESOP consists of the current employee base, those employees will likely be interested in maintaining the business practices and culture you have established over the years. The workforce will be motivated to continue to perform well and grow since many are now part owners. For owners who want to continue to stay involved, there is this benefit: ESOPs can be designed to retain control of the business and its management.
Complexity: In reality, any sale is complex, but ESOPs are especially nuanced. In addition to the need to hire ESOP consultants, lawyers, and a trustee to perform the upfront feasibility, valuation and plan design for the transaction itself, ESOPs require ongoing compliance, including but not limited to annual valuations. However, if the complexity does not feel daunting, ask your financial planner if they will help with an initial feasibility study.
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