An ESOP, or an Employee Stock Ownership Plan, can be an attractive exit route for business owners. It can provide a path to “take chips off the table”, sustain the business culture, motivate employees, and ensure that employees have a future with the business. Selling owners can also have more control over the timing of their departure from the business, with the most enticing aspect often being the favorable tax consequences of a transaction.
These are indeed compelling reasons to move toward an ESOP for an owner who wants to mitigate taxes while at the same attain pronounced values-based goals. An ESOP can indeed be a rewarding exit strategy for all stakeholders in the right situation.
There are however drawbacks that Business Owners should understand and plan for with rigor (with an experienced advisor team) prior to implementing an ESOP strategy. Following are some key planning issues:
Realizing Owner Financial Goals
There are financial risks that an owner needs to understand, mitigate with planning, and be willing to assume as they execute an ESOP:
The management team will need to run and grow the business successfully. If they don’t, there may not be adequate cash flow to pay off the debt owed to the selling owner(s).
It is often necessary for the selling owner(s) to accept a promissory note for part of the purchase price. There is a risk of non-payment if the business does not have adequate cash flow to make loan repayments.
The owner(s) may also be required to personally guarantee bank financing that is used in purchasing their stock. If the selling owner(s) has pledged sale proceeds as security for the bank loan or has not received the entire purchase price at closing, the owner risks losing the unpaid portion of the sale proceeds, if they are no longer involved in the business or have control.
Establishing and operating an ESOP can be expensive.
An ESOP transaction may not be as financially beneficial as compared to a sale to a strategic buyer.
Next-Level Management Team and Other Business Considerations
A “next-level” Management Team, that can operate well in an employee-ownership environment capable of taking the business to the next level of growth, is critical for a successful ESOP transaction.
If employees observe ineffective management, it can impact their perspective on the future growth of the business and their ownership interest in the business. This could result in employees leaving when a goal for the ESOP was employee retention.
ESOPs can put a strain on the future cash flow of the business in repaying the loan if the owner’s stock sale was financed. Also, the obligation to purchase stock from the ESOP accounts of departing employees can result in further cash flow challenges.
The level of due diligence is like that of a sale to a third party. This will require time and attention, which can result in a lack of focus on managing current business growth.
Properly executed ESOPs produce favorable tax consequences, resulting in a high level of scrutiny and regulation by the IRS and Department of Labor.
The ESOP exit route may be the most complex requiring the deepest level of expertise for analysis, feasibility, and implementation. Make sure to get the right experts on your advisor team early in your process, as it can take years to prepare your business for a successful transaction.
Following are ExitReadiness® PODCAST episodes focused on ESOPs that will prove helpful: