How Does an ESOP Work?

Axial

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

Many owners are now considering selling their businesses as they approach retirement age. When considering their exit strategies, they face difficult decisions for monetizing the enterprise value of their businesses. While a business owner wants to receive a desirable price for the business, he or she may not want to sell to a third party (e.g., a strategic buyer or a private equity firm). The owner may instead want to reward loyal employees who have made significant contributions to the business’s success. If the owner is willing to receive fair market value vs. strategic market value, an Employee Stock Ownership Plan (ESOP) may be a practical exit strategy. Fair market value, which is based on the historical performance of a company, is typically less than strategic market value, which also takes into account future synergies.

Recently, SDR Ventures advised a client in a sales transaction in which the owner chose to execute an ESOP transaction versus other exit options available to him. Of utmost concern to this owner was rewarding his employees and keeping his legacy in-house.

How does an ESOP work? Below is a brief synopsis of this type of exit plan.

What Is an ESOP?

It is a type of qualified retirement plan similar to a profit-sharing plan, but with one main difference. An ESOP is required by statute to invest primarily in shares of stock of the ESOP sponsor (i.e., 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:

1) provide tax incentives for owners of privately held companies to sell their companies; and

2) provide ownership opportunities and retirement assets for working-class Americans.

How Does an ESOP Work?

In a typical leveraged ESOP transaction, a corporation’s board of directors adopts an ESOP plan and trust and appoints an independent ESOP trustee. After obtaining an independent appraisal of the value of the corporation’s equity, the ESOP trustee negotiates the purchase of all or a portion of the corporation’s issued and outstanding stock from one or more selling shareholders. Often, the corporation sponsoring the ESOP will borrow a portion of the purchase price from an outside lender (the “outside loan”) and immediately loan the proceeds of the outside loan to the ESOP (the “inside Loan”) so that the ESOP can purchase the shares.

The two-phase loan process is used because lenders generally are unwilling to comply with restrictive ERISA loan requirements. If only a portion of the purchase price is funded with senior financing, the remaining portion of the purchase price generally will be funded through the issuance of subordinated promissory notes to the selling shareholders, whereby the sellers receive a rate of interest appropriate for subordinated debt.

leveraged - employee stock ownership planTo provide the ESOP the funds necessary to repay the “inside loan,” the corporation is required to make tax-deductible contributions to the ESOP each year, similar to contributions to a profit-sharing plan. Upon receipt of these annual contributions, the ESOP trustee uses the funds to make payments to the corporation on the “inside loan.” In addition to these contributions made to the ESOP by the corporation, the corporation can declare and issue tax-deductible dividends (C-corporation) or earnings distributions (S-corporation) on shares of the corporation’s stock held by the ESOP which, in addition to employer contribution, can be used by the ESOP trustee to pay down the “inside loan”. Shares purchased by the ESOP from selling shareholders (or the corporation) are held in a “suspense account” within the ESOP trust. As the ESOP trustee makes its annual principal and interest payment on the “inside loan,” shares of the corporation’s stock acquired by the ESOP from the selling shareholders (or corporation) are released from the suspense account and allocated to the separate ESOP accounts of employees participating in the ESOP.

View Part I of this article on Axial Forum >

Continued…

For those considering an ESOP as an exit option, here are a few advantages and disadvantages of this strategy.

Advantages of an ESOP

The tax benefits of an ESOP exit strategy can be significant. These benefits accrue to the selling shareholder(s) (the corporation), and to the employees who participate in the ESOP. The tax benefits to the selling shareholder and corporation vary depending on whether the corporation is taxed as an S-corporation or as a C-corporation.

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

  • A ready-made market for the owner’s stock
  • A ready-made buyer for the owner’s business
  • A lower marketability discount (typically 5 to 10 percent) when valuing shares on a “fair market value basis” vs. a “strategic market value basis”, since the ESOP is the market for those shares
  • A business owner who 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 or other third parties
  • A retirement benefit for employees
  • An avoidance of integration plans and their associated costs to restructure operations, reorganize management or reduce staff because management and staff continue in place after the transaction closes
  • An 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

Disadvantages of an ESOP

There are also several disadvantages of ESOPs to consider. Like most business decisions, there are trade-offs with 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 ERISA. High fiduciary duty standards must be met. This adds additional costs to the corporation including the cost of:

  • Retaining an independent trustee, an independent financial advisor and independent legal counsel to advise the ESOP trustee
  • Engaging qualified ESOP counsel experienced with ESOP stock purchase transactions in addition to corporate counsel
  • Ongoing administrative, fiduciary and legal expenses associated with an ESOP that might not be present in a sale to a third party
  • Maintaining the ESOP plan and trust documents, a record-keeper/third-party administrator, a trustee and annual valuations of the share value of the ESOP
  • Calculating the amounts of tax-deductible contributions made to the ESOP each year
  • Monitoring who can participate in the ESOP depending on the Code section 1042 election, even if they are employees of the corporation
  • Implementing the anti-abuse provision, Section 409(p), which restricts any one participant or family from receiving excessive share allocations in the ESOP or other synthetic equity issued by the corporation
  • Obligating the corporation to have a stock repurchase plan (this requirement must be monitored and funded on an ongoing basis for participants who are eligible to receive a distribution of their ESOP stock accounts as they retire or terminate employment. The corporation is then required to repurchase the stock at the current fair market value).

As can be seen from the discussion above, ESOPs are highly technical and complex. If a business owner is considering an ESOP as an exit strategy, careful planning and retention of experienced professional advisors, including a wealth management firm, a qualified ESOP tax advisor and a qualified ESOP transaction law firm, are musts.

View Part II of this article on Axial Forum >

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Gary Miller is managing director of Denver-based SDR Ventures Inc.’s consulting division. SDR is an investment banking firm that advises privately held middle-market businesses. Miller specializes in helping companies prepare for sale, exit planning, company valuations, strategic business planning and M&A consulting. He can be reached at 720-221-9220 or gmiller@sdrventures.com. For more info about SDR Ventures’ consulting division, please click here.