An ESOP Could Be an Alternative Exit Strategy for Business Owners

The Denver Post

Business

Gary MillerBy Gary Miller – Managing Director, Consulting Division, SDR Ventures

As business owners approach retirement age, many consider selling and often face difficult decisions related to the value of their enterprises.

While a business owner wants to receive fair-market value for the business, he or she may not want to sell to a third party. The owner may want to reward loyal employees who have made significant contributions to the success of the business, and for these owners, an employee stock ownership plan, or ESOP, may be a practical exit strategy.

What is an ESOP? It is a type of qualified retirement plan similar to a profit-sharing plan with one main difference. An ESOP is required by statute to invest primarily in shares of stock of the ESOP sponsor (the corporation selling the stock). Unlike other qualified retirement plans, ESOPs are specifically permitted to finance the purchase of employer stock by borrowing from the corporation, other lending sources or from the shareholders selling their stock.

When Congress authorized ESOPs in 1957, and defined their rules in 1974, it had two primary goals: to provide tax incentives as a vehicle for owners of privately held companies to sell; and to provide ownership opportunities and retirement assets for working-class Americans.

How does an ESOP work? The corporation’s board of directors adopts an ESOP plan and trust and appoints an independent ESOP trustee. An appraisal of the corporation’s equity is obtained. The trustee negotiates the purchase of all or a portion of the corporation’s issued and outstanding stock from one or more selling shareholders.

The corporation may borrow funds for a portion of the shares from an outside lender and loan the proceeds to the ESOP so the ESOP can purchase the shares. (Rarely does the corporation have enough cash on its balance sheet to loan to the ESOP; hence the corporation typically will borrow from an outside lender.)

The corporation is required to make tax-deductible contributions to the ESOP each year, similar to contributions to a profit-sharing plan. The trustee uses the funds to repay the outstanding loans. In addition to the mandatory contributions, the corporation can declare and issue tax-deductible dividends or earnings distributions on shares of the corporation’s stock held by the ESOP. Often the trustee will use these dividends/distributions, too, to pay down the ESOP’s loans.

Tax benefits of an ESOP exit strategy accrue to the selling shareholders, the corporation and the employees who participate in the ESOP. The tax benefits to the selling shareholder and corporation are significant.

Nontax advantages of an ESOP exit strategy are many and should be considered by the business owner depending on the owner’s goals. Some of the advantages:

  • A ready-made market for the owner’s stock or business.
  • A business owner can gradually transition the ownership over a period of time and thus remain actively involved in the business.
  • A vehicle for the owner to receive the desired liquidity without selling to a competitor.
  • A retirement benefit for employees.
  • Avoidance of integration plans and associated costs to restructure operations, reorganize management or reduce staff because management and staff continue in place after the transaction closes.
  • Avoidance of giving out confidential information to a competitor or other potential buyers.
  • A long-term financial investor — the ESOP — that will not seek to sell the corporation in a relatively short time period.

Like most business decisions, there are trade-offs to any exit strategy. An ESOP is no different.

It is important to remember that an ESOP is a qualified retirement plan governed not only by the Internal Revenue Code, but also by the fiduciary and disclosure rules of the federal Employee Retirement Income Security Act.

The cost of meeting these fiduciary duty standards can be high, including hiring financial and legal advisers to the ESOP trustee and the seller, as well as additional expenses related to ongoing administrative management.

ESOPs are highly technical and complex. If business owners are considering an ESOP as an exit strategy, careful planning and consideration among professional advisers, including a wealth management firm, a qualified ESOP tax adviser and a qualified ESOP transaction law firm are musts.

Gary Miller is managing director of Denver-based SDR Ventures’ consulting division. SDR is an investment banking firm that advises privately held middle-market businesses. Miller specializes in strategic business planning, and merger and acquisition and exit-strategy consulting. He can be reached at 720.221.9220 or gmiller@sdrventures.com.

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2018-02-12T17:49:58+00:00 Press, Small Business, Strategic Planning|