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

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Andrey O, Investor

“Finally enjoying retirement after recently selling my business using the services of A Neumann & Associates. Joe Oddo provided the conduit to a successful transaction. Joe knew when to inject input and when to simply listen and allow the buyers to vent, step back and regroup. The outcome met our expectations and got us to the finish line, which included my staying with the company six months in order for the buyers to get their footing and keep our workforce in the loop. He helped at every step by providing his expert guidance & resources. Thank you!”

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“Thank you for your Event on "How to value, Sell, and Buy A Business for Maximum Profit" and the insight into ANA’s approach on what is involved in the Business Exit for sellers. Garys Hervieiou's "Business Valuation", Achim's "Deal structure" presentation and Karin’s "Preparing the Package" are real street knowledge shared. They answered attendees questions which makes it more interesting for learning from others. Great for small businesses like us. The presentations were totally worth our time and travel for the event to Princeton, NJ from Rockville MD. Ravi Bhutani, President, CIPS”

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“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.”

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