Is an ESOP a Good Idea?

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.