ESOP as alternate exit strategy

Quite frequently, we are confronted by retiring business owners with the question, if it’s not more favorable to use an ESOP (Employee Stock Ownership Plan) as an exit vehicle instead of selling outright to an investor. The aforementioned question is often motivated by one of two aspects, namely, either the emotion to “do good” by the employees after all their years of service and to establish a legacy for the company, or, more often by the financial underperformance of the company, in essence making it difficult to find an investor on the open market.

The ESOP has been in existences since 1974 and has been part of the corporate finance environment ever since.  By one estimate there are 7,000 active plans today with 13 million participants. ESOPs are mostly used to create a market for the stock of a departing owner of a closely held company, to take advantage of tax incentives to borrow money for acquiring new assets in pretax dollars, or to reward (or motivate) employees. Generally, ESOPs are not an employee purchase but rather a contribution or distribution to the employees.

How does it work?  A company creates a trust fund / plan (ESOP) contributing new company shares / stock – or cash to buy existing shares – with such contributions to the trust being tax-deductible to certain limits. ESOP shares are then allocated to individual employees either on the basis of relative pay or some other more equal formula. As employees accumulate seniority with the company, they are ‘vesting’ an increasing right to the shares in their account – usually 100% vested within three to six years. Upon leaving their role, the company must buy back the stock from the employees at fair market value, subject to an annual outside valuation. In addition, withing private companies, employees must be able to vote their allocated shares on major issues.

However, by simply creating an ESOP and contributing cash or company stock, the parting business owner looking to ‘sell’, rather than to give away his company, accomplishes little – other than the tax deduction the company receives for its contributions.

More often, though, a leveraged ESOP is created: money is borrowed to buy the company’s existing shares from the owner at a Fair Market Value, whereas the company’s future profits result in cash contributions to the ESOP plan enabling it to repay the loan.

And here is where the rub is: first, the loan to the newly created ESOP needs to be guaranteed to the bank. Short of the company having considerable hard assets for an asset lender, or a very strong cash flow for cash-flow-based lender, all on the basis of predictable year-to-year, consistent cash flow performance, the bank will most likely seek a loan guarantee from the current owner – leaving the departing owner with considerable loan exposure. More significantly, the ESOP takes away the company management from the current (presumably successful) business owner and transfers it to the employees  – a position often not very fondly viewed by lenders respective a smooth transition of successful management.

In other words, the business owner has relinquished control of the company, but is responsible for the loan that buys his own company. Not a desirable position to be in!

Additionally, the costs of an ESOP are substantial, not only in its creation due to the many specialty advisors, but also due to proper third party administration, trustees, legal costs and annual valuations. Such new (additional) administrative costs might very well overburden mid-sized companies trying to maintain their profitability. Another factor often underestimated is the trust’s constant need to be prepared to buy parting employees’ stock back – a factor that might have considerably negative cash flow impact during an economic down turn with associated lay-offs, a time when there is little cash flow to begin with.

In sum, whereas there might be certain situations where an ESOP makes sense, generally, owners of privately held mid-sized business are generally better advised to sell their business on the open market. This will not only allow obtaining the best price, it will also free the owner from substantial financial exposure subsequent to exiting his company.