Mergers & Acquisitions Advisory

A Neumann & Associates, LLC

April 22, 2021

Is an ESOP a Good Idea?

By Achim Neumann

Esop

Imagine you are a business owner who has built a successful company over the past 25 years and are now ready to retire to pursue all things you never had time for. Obviously, you want to “cash out” after all the years of hard work – and are entitled to do so – but perhaps you also want to take care of your employees by transferring ownership of the business to them. You are thinking that an ESOP (Employee Stock Ownership Plan) would accomplish this, generate funds for your retirement, create tax benefits and “reward” the employees with business ownership. Great, right? Not so fast.

“We are often asked by retiring business owners, if it is more favorable to use an ESOP as an exit vehicle instead of selling outright to an investor, ” says Achim Neumann, President, A Neumann & Associates, a Merger & Acquisitions and business brokerage firm, headquartered in New Jersey, “this may be motivated by the emotion to preserve the legacy of the business while “thanking” the employees after all their years of service. Occasionally, we see this is driven by the business owner’s belief that it will be difficult to find an investor on the open market as the business is financially underperforming but there is a need to receive payment in the near term. “

ESOPs have been in existence since 1974 with approximately 6,600 active plans today and 14 million participants. ESOPs are mostly used to take advantage of tax incentives to borrow money for acquiring new assets in pretax dollars by creating a market for the stock of a departing owner of a closely held company, or to reward (or motivate) employees. Generally, ESOPs are not truly an employee purchase but rather a contribution or distribution to the employees.

How does it work?

A company creates an ESOP contributing new company shares / stock – or cash to buy existing shares – with such contributions to the ESOP being tax-deductible to certain limits. The pool of ESOP shares are then allocated to individual employees either on some basis (tenure, position, pay level, etc.). As employees accumulate seniority with the company over a period of time, they are ‘vesting’ an increasing right to the shares in their account – usually 100% vested within four to six years. Upon leaving their role with the business, the company must buy back the stock from the employees at Fair Market Value, subject to an annual outside valuation. Additionally, within private companies, employees must be able to vote their allocated percentage of shares on major issues.

By simply creating an ESOP and contributing cash or company stock, the parting business owner is accomplishing little for the business other than creating the tax deduction the company receives for its contributions. They are not “selling” the company, in effect they are “giving it away” and often creating a leveraged ESOP: money is borrowed from the company to buy the existing shares from the owner at a Fair Market Value. The company’s future profits generate cash contributions to the ESOP plan enabling it to repay the original loan.

Here is where the challenges start.

First, the bank requires a guarantee on the loan to the newly created ESOP. Short of the company having considerable hard assets for an asset lender, or a very strong cash flow for a cash-flow-based lender, the bank will most likely seek a loan guarantee from the current, soon to be departing, owner. More importantly, the ESOP takes away the company management from the current (presumably successful) business owner and transfers it to employees unproven at running a business – a position often not very fondly viewed by lenders seeking a smooth transition of successful management.

In other words, the business owner has relinquished control of the company, but is personally responsible for the loan that buys his own company.

So much for a stress-free retirement!

ESOPs are often expensive to create or maintain. Often, they require specialty advisors, proper third-party administration, trustees, legal costs and annual business valuations. These additional administrative costs are often not considered early on and might very well overburden mid-sized companies trying to maintain their profitability. Another factor often underestimated is the potentially constant need to be prepared to buy parting employees’ stock back – a factor that might have considerably negative cash flow impact during an economic downturn or when there is little cash flow to begin with, great example, 2020.

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 in a confidential manner with a professional M&A Advisor. This will not only provide the business owner with the best price, it will also free them from substantial financial exposure subsequent and allow them to truly enjoy their retirement.

About A Neumann & Associates, LLC

A Neumann & Associates, LLC is a professional mergers & acquisitions and business brokerage firm having assisted business owners and buyers in the business valuation and business transfer process through its affiliations for the past 30 years. With an A+ Better Business Bureau rating, the company has senior trusted professionals with a deep knowledge based in multiple field offices along the East Coast and has performed hundreds of business valuations in its history. The firm’s competitive transaction fees are based on successfully completing transactions. For more information, please contact A Neumann & Associates at 732-872-6777 or info@neumannassociates.com

Leave a Reply

Your email address will not be published. Required fields are marked *

four × 2 =

Any questions? Please contact us at 732-872-6777
Call Now

Client Testimonials

“I recently contacted A. Neumann and Associates about getting a valuation of my business done. I spoke with Marc, who explained the process in detail. After meeting with Marc in order to get a clear understanding of my business, and what I was hoping to accomplish. His patience in answering all my questions and his knowledge of the proper way to market my business gave me great confidence that this is the firm I will be using to sell my business for max value. Working with Marc at A Neumann & Associates was very easy and professional. I did not know all that was going to be involved in selling my business but they helped me through the process. What I thought was going to be a just another one of those pushy sales companies was just the opposite. Polite, knowledgeable, and a pleasure to talk to and deal with. I highly recommend this firm to anybody who wants to sell now or down the road. Marc not only knows his stuff, but actually is a real nice guy.”

Double Diamond

“Used A Neumann & Associates to sale my business. could not imagine having done it with out the patience and experience Gary provided. Thanks Gary,”

Dennis Frazier

“Working with Marc and his company was a pleasure. What I thought was going to be a just another one of those pushy sales companies was just the opposite. Polite, knowledgeable, and a pleasure to talk to and deal with. Marc handled most of the interaction and he has one of the greatest demeanors. Again, it was a pleasure working with him and his firm.”

Douglas DiCeglio

“I recently completed an acquisition using A Neumann & Associates. Tony Valentino was very helpful and accessible during the entire process. They do a thorough job vetting both parties and got us to the finish line.”

Srini Mudambi

“Claus out of Florida helped us with the sale of our business. We had never done anything like this and him and his team walked us through the process from start to finish. We had some challenges through the process and Claus continued to show up even in the difficult conversations.”

Colby Harris, Co-Owner, Del Mar Designs

“Claus Madsen thoroughly helped us with selling our company. From the 1st introductory meeting explaining to us what was possible, to providing us with resources to assist with the sale. Claus was invaluable throughout the whole sales process. Claus was with us every step of the journey and always made himself available for any questions or issues that came up along the way. If you are interested in selling your business, I encourage you to reach out to Claus and the ANA team so that they can let you know what’s achievable. These guys will make it happen!”

Ron Harris, Co-Owner and Vice President, Del Mar Designs

“A Neumann & Associates is the only business broker I would use or consult with. They have assisted with 3 business sales over the past 15 years with me. They are honest and sincere and have always performed better than my expectations. They are the only one i would use for the sales of my businesses.”

James Belanger, Business Owner

“I wanted to take a second to commend the exemplary customer service from both you [Karin Neumann] and Mr. Valentino. It’s both a rarity in the industry, and very much appreciated.”

Andrew G., Investor

“We worked with Neumann & Associates to investigate the purchase of a research company in 2010 and found Achim to be capable, forthright and realistic. His depth of experience enabled us to fully understand our options, offering creative options that might enable the acquisition. While we didn’t acquire that particular company at that time, we know exactly who to call whenever we’re looking to buy or sell a business.”

Daniel Coates, Buyer

“Purchasing a business through this firm was a pleasure. Gary was very professional and transparent throughout the entire process. I look forward to working with A Neumann & Associates in the future.”

William Klemens, Buyer
view all testimonials

Contact A Neumann & Associates, LLC

If you are considering selling your business, please contact us to learn more about our comprehensive service spectrum. Our experienced professionals will answer all your questions about selling a privately held business in complete confidentiality. Please fill out our contact form, or call us at 732-872-6777. We will contact you directly and will never identify ourselves to your employees.

call us now
Contact Us for a Free, Confidential Consultation

Experienced M&A Advisors available

Full Name
Email Address
Phone Number
Message