ESOPs Today: A Powerful Tool for Realizing Business Value & Succession Planning Why do a growing number of entrepreneurs at retirement sell the family business to their employees? What makes an Employee Stock Ownership Plan (ESOP) right for the times?
As the Silver Tsunami crests and Baby Boomers retire, America is looking at the biggest transfer of wealth in our history: trillions of dollars. Owners of closely held businesses as many as 2.3 million companies 1 are looking to sell. That s more than 90 percent of U.S. firms 2. It s also a notable trend among family businesses, as the next generation decides to follow different footsteps. New legislation makes an ESOP even more attractive The new Main Street Employee Ownership Act has made an ESOP option available to a greater population of closely held businesses, says Steve Dowe, Senior Vice President at Webster Bank. The new law, backed by strong bipartisan support, has the potential to double or even triple the growth rate 3 of ESOP companies over the next ten years. But that s just the beginning of ESOP s benefits to employers and employees alike. Why employers are taking a closer look at ESOPs An ESOP conversion is an alternative ownership transition strategy that creates significant tax benefits for the seller and the business. An ESOP can provide for full or partial liquidity for the owner of a closely held company; at the same time, it enables the tax-efficient transfer of value to the next generation of management and employees. Sellers of shares may be able to defer capital gains tax on the sale, reduce corporate taxes, and entirely eliminate the tax burden for a 100% ESOP-owned S corporation. For employers, selling to employees solves a number of problems: Continued Ownership Legacy Liquidity Sellers remain vested and maintain a meaningful stake in the business. Sellers preserve the legacy of the business and the brand they created. ESOP sales create significant liquidity in a tax advantaged manner. Management/Employee Loyalty It prevents a sale to an outsider who might move it out of state or flip it, displacing dedicated employees. It fulfills the altruistic founder s wish: to keep the business viable to support its staff and their families. It honors the owner s loyalty to the management team. They may have unique skill-sets that are hard to duplicate with a third-party buyer. 1 https://www.project-equity.org/wp-content/uploads/2018/07/project-equity-national-small-business-closure-crisis.pdf 2 https://www.inc.com/encyclopedia/closely-held-corporations.html 3 http://www2.philly.com/philly/business/rutgers-profs-as-boomers-age-small-business-owners-get-new-incentive-to-sell-to-employees-20180815.html
Options for owners who want to keep their hand in the business Some sellers may be interested in only selling part of a business. They may be looking to diversify their holdings or set the stage for estate planning. In those cases, an ESOP provides structural flexibility: The seller can sell a fractional amount of the company to an ESOP to crystalize liquidity while maintaining a significant stake or potentially a controlling interest (if selling less than 50% of the company) and continuity of management. The owner doesn t have to bring in a competitor or outside buyer as a partner. (It s no small point that many entrepreneurs or owners of multi-generational businesses are not interested in working for someone else.) Rather, the company s own dedicated employees are the new partners. Given near-comparable economics to alternative forms of sale, many sellers highly value a partial sale for three reasons: They can remain active in the company; They can offer their employees an opportunity to benefit from ownership; and They can continue the legacy of the company they may have created. How ESOPs keep employee motivation high An ESOP allows the workers to build capital. That reduces income inequality and gives them a vested interest in the company s success. In fact, ESOP companies have higher productivity and revenue 4 than their competitors. Research has even revealed that customers will pay 10% more 5 for products and services of an ESOP business recognition of higher quality and the employee/owners 100% dedication to the company s success. For these and other reasons, ESOPs are a compelling solution that can be a win-win for all parties. Four crucial considerations for optimizing an ESOP 1 Developing an optimal capital structure 1. Developing an optimal capital structure Leverage must be reasonable based on the fair market value of the stock. It also must be within the company s ability to repay debt and meet other financing obligations. The tax deductibility of allowable annual plan contributions impacts cash flow and the ability to meet other funding obligations, such as repurchasing the shares of employees who leave the Owners need to plan carefully with their advisors to achieve the right balance. 4 https://www.nceo.org/articles/studies-employee-ownership-corporate-performance 5 https://www.nceo.org/articles/surveys-show-strong-preference-employee-owned-products-services
company. Both the timing of vesting of shares and of employee termination can affect the viability of an ESOP. Owners need to plan carefully with their advisors to achieve the right balance among the competing interests of the sellers, plan participants, and the trustee. That s why it is critical to work with skilled advisors who understand the fine points of ESOP transactions and can develop a feasible financing arrangement. 2 Establishing fair market value of company stock 2. Establishing fair market value of company stock Valuation is a critical ESOP issue. The ESOP cannot pay more than fair market value for stock it acquires. The advisor should establish an appropriate value for the seller that is consistent with the trustee s stock valuation. It should also be supported by an independent appraisal. Potential conflicts or inadequate assessment of fair market value can lead to disputes and potential lawsuits. In addition to the valuation when stock is sold or contributed to the ESOP, the stock also requires an ongoing annual valuation. ESOP participants selling shares must receive fair market value and the company has to meet all of its repurchase obligations to employees. There are several options to fund those obligations. An astute advisor can help you navigate them to comply with ESOP rules and avoid financial problems down the road. 3. Managing transaction costs and fees ESOP participants selling shares must receive fair market value. 3 Managing transaction costs and fees There may be significant administrative, legal, and compliance expenses with implementing and ESOP. How much can that cost a small business? Actual costs of course depend on your specific situation but getting the tightest possible fix on your ESOP transaction costs is critical to the plan s feasibility. 4. Finding a lender who understands ESOPs Senior lenders may understand asset-based or cash-flow lending but may not know much about ESOPs. In certain cases, they may only have limited knowledge of the business or market. A fundamental understanding of the business dynamics and ESOP knowledge are essential to appropriately structure and finance an ESOP transaction. Michael J. McGinley, director of Prairie Capital Advisors, who specializes in ownership transition services, makes this recommendation: Getting the tightest possible fix on your ESOP transaction costs is critical to the plan s feasibility. 4 Finding a lender who understands ESOPs Having a financial partner who has ESOP expertise and an understanding of the local market is an invaluable asset. That s especially important because ESOPs can require refinancing across the life of a deal. That calls for a strong relationship with advisors who appreciate the business real-world challenges and can respond promptly. Understanding of the business dynamics and ESOP knowledge are essential to appropriately structure and finance an ESOP transaction.
Webster delivers creative solutions to support your ESOP and maximize shareholder value For decades, Webster Bank has been helping privately owned businesses transition to new stages in their life cycle, including structuring and financing ESOP conversions. Webster s strong middle market platform, deep industry experience, and leveraged lending expertise have made us a go-to resource for tailored cash flow financing solutions in support of ESOP transactions. - Steve Dowe Steven Dowe Email: sdowe@websterbank.com Office: (212) 806.4503 Mobile: (917) 655.9955 All credit facilities are subject to the normal credit approval process. The Webster symbol is a registered trademark in the U.S. Webster Bank, N.A. Member FDIC. Equal Housing Lender 2018 Webster Financial Corporation. All rights reserved.