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.

Will Deciding on Exit Strategy be Easy or Difficult?

For most small business owners, deciding as to how they exit will be easy, because they will have few options.

The majority of small business owners, based on research, will choose between selling assets to a third-party buyer or simply shutting down when they’re done being a business owner. To realize the maximum number of options for exit, an owner needs to invest both time and money, and few do this systematically and strategically over time with the end in view. The result is fewer options for exit and a forced “easy exit decision”.

Those of you who do plan, build a business that is transferable, and hence have more exit options, might be (in a good way!) further challenged when making the final decision as to what exit path to execute.

Betty founded her business over twenty years ago, and was strategic in her approach to building a transferable business and planning for her eventual exit — she continually had the end in view when planning for business growth today. From the beginning, Betty’s plan was to eventually sell to a third-party buyer and that is absolutely a current possibility as she’s recently been approached by a few potential buyers. Betty would now like to leave completely in the next 2-3 years, so a sale with an earnout could be the answer.

However, Betty now has other interests and goals, in addition to her financial goals — she has two children in the business that have shown interest and promise in being future owners — Betty would very much like to see the values and culture of the business sustained in the future — and finally, she’d like to ensure the future of key employees who have helped her grow the business through the years. These “values-based” goals more align with either an ESOP (Employee Stock Ownership Plan), sale to a key employee group, or transfer to the children.

The good news for Betty has many options for exit, so she can give legitimate and serious consideration to all of her values-based and legacy goals.

More challenging for sure, but good challenges as Betty has the flexibility to accomplish all of her goals in choosing the best-aligned exit strategy. She is not limited as to her options — Betty is positioned to do a third-party sale, sale to insiders, an ESOP, a transfer to children, or a combination.

Betty is again enjoying the benefit of having an experienced and trained Exit Planner assist in thinking through all the pertinent issues.

In Betty’s case, there is an understanding that having a “tough exit decision”, is actually a good thing because it’s due to her various exit options and goals. Betty’s Exit Planner helped to get her to this point and is again adding value in designing and implementing the final decision. She is grateful for the exit options available to her and the flexibility for personal goal attainment which are the good fruits of wisely investing in a strategic exit plan from the inception of her business.

Invest 12-15 minutes in the FREE ExitMap® Assessment and get a 12-page report scoring you in four key exit planning areas: Finance, Planning, Revenue/Profit, and Operations.