To ESOP or not to ESOP...

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:

A Successful ESOP Story Ft. Kris DenBesten

ESOPs As An Exit Route ft. Keith Apton

Contact us today if you need help in determining if an ESOP is your best exit strategy.

Key Employees and Building and Protecting Business Value

You may have people working in key roles who are instrumental in growing and building the value of your business. These key people can be identified as having the following characteristics:

• makes a substantial business contribution

• possesses critical information or knowledge or

• maintains and nourishes key contacts and relationships

In helping clients plan to build a business that’s sellable, and then eventually exit on their own terms and conditions, we emphasize that “key people are a key value driver “ in realizing success in both of those strategic goals. And, we find it helpful for owners to have two categories in mind when considering key employees:

1. Building business value

2. Protecting business value

Key people help owners build value and exit successfully as their roles serve in removing the owner(s) from the day-to-day management of the business, and by accomplishing objectives and key results for growing the business, that are aligned with the exit goals of the owner(s). An important planning focus for the owner(s) in building value, as it pertains to key employees, would include alignment of the employee’s performance goals with the exit goals of the owner(s), and a well-defined key employee incentive plan that provides impactful awards for goal attainment and retention.

Owners need to be aware, that there is also inherent risk related to key employees. Risks involving departure and competition, solicitation of customers and/or employees, and disclosure of confidential information. There is also the risk of losing a key employee due to unexpected death or disability. It can be costly to recruit, train, and compensate for a replacement in such a situation, as well as makeup for any loss in corporate earnings. Important planning areas in protecting business value, as it pertains to key employees, would include: Well-written and regularly reviewed employee documents (i.e., Employment Agreement; (listen to ExitReadiness® PODCAST Episode 43 w/attorney Marc Engel) and adequate life insurance coverage on the key employee (listen to ExitReadiness® PODCAST 54 w/Bill Betz of Betz Financial Advisory).

Check out our virtual exit planning resources and solutions at exitreadiness.com

Characteristics of an ESOP for an Owner's Exit Route

As an entrepreneur who has spent years working to grow a privately held business, you are left with many questions about transitioning to the next stage of your life.  The biggest question usually is, "what is the most efficient way for me to sell my business?"  Since the increase in capital gains taxes and surge of baby boomers retiring, the use of Employee Stock Ownership Plans as a monetization strategy has been a growing trend.

An Employee Stock Ownership Plan (ESOP) is a flexible, tax efficient exit strategy that offers a variety of advantages to successful business owners.  ESOPs provide a unique way for business owners to sell a portion or all of their stock on a tax-advantaged basis, while simultaneously rewarding loyal employees.   In certain cases, with the right structure, the sellers can avoid the capital gains taxes from the sale.  After a transaction, if so desired, the selling owner has the ability to retain control of the company.  The company can also operate on a tax-advantaged basis with the right structure.

When considering an ESOP, it is important to understand what features make up a good candidate.  When having this conversation with clients and prospects, we like to break this down into quantitative and qualitative characteristics. 

What makes a good ESOP candidate?     

Quantitative characteristics:

·       The company must have positive cash flow and the ability to take on additional debt.  An ESOP is a leveraged buy-out and you need cash to repay the debt associated with the transaction.

·       The company should have at least 20 employees

·       The enterprise value of the business should be greater than $5 million

Qualitative characteristics:

·       The selling shareholder(s) should be prepared to stay on with the business for some amount of time to help with the overall transition

·       There should be a strong management team in place to help take over and run the business after the selling shareholder(s) leave

In conclusion, when used effectively, an ESOP is a powerful, flexible, tax and business succession tool for privately held companies.  We would welcome the opportunity to discuss ESOPs and the pros and cons with you or your clients.  Please call us at 202-585-5358.  Sincerely - Keith Apton, Managing Director-Wealth Management, UBS Financial Services.   

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