Companies large and small are reaping the benefits of Employee Stock Ownership Plans. Should yours be next?
Please note: Although the information contained in this article is presented in good faith and is believed to be correct, it is general in nature and is not to be construed as tax advice. It should not be used in any actual transaction without the advice and guidance of a professional tax advisor who is familiar with all of the relevant facts.
by Karin O’Connor
What if you could. . . extract liquidity from your private company ownership, defer taxes on your capital gain, maintain control and decision-making authority, and incentivize your team. . . .all at the same time? Structured properly, and under the right conditions, selling all or part of your stock to your employees via an Employee Stock Ownership Plan (ESOP) can get you there and is an option you ought to consider. Indeed, according to the National Center for Employee Ownership, over 7000 companies covering about 13.5 MM employees, have done just that since Congress set up the rules in 1974.
An ESOP is a qualified employee benefit plan, but, unlike other types of plans such as 401 K’s, it is set up primarily to acquire the employer company’s own stock. Mechanically, the company establishes a trust which purchases stock from one or more selling shareholders (e.g. the company’s founder(s)) on behalf of its employees. Shares are allocated to each employee over time according to a vesting schedule, and employees have the ability to sell their vested shares back when they reach a certain age, leave the company, or retire. Effectively, the employees become owners of the business—with the ability to profit directly from growth in its value over time.
For the selling shareholder, the program comes with several key advantages. First, a founder can sell just part of the company, taking some cash off the table to diversify his/her portfolio while still running the business and maintaining control. And, if the company is structured as a C-corp and the employees acquire at least 30% ownership, the seller’s capital gains tax can be deferred indefinitely (potentially a huge plus given that most founder’s basis is extremely low). Many ESOPs are leveraged (i.e. borrow money from a bank to finance the acquisition of shares), and, if this is the case, the company is able to deduct payments of both interest and principal from its taxable income, an ability that can generate big cash flow benefits. (Note: Many private companies are structured as S-corps. ESOP tax benefits to an S-corp, though different in nature, can also be quite significant.)
Even if an owner wishes to sell most or all of the business, an ESOP transaction can carry major advantages over a sale to an outsider. For one thing, the sale process may be more efficient, since the prospective buyer (the employee’s interests will be represented by a trustee and overseen by expert advisors) is already familiar with the company’s business model, market, operations, and prospects. For another, a sale to an outsider is almost always highly disruptive to employees and customers, while an ESOP transaction, with culture maintained and operations consistent, creates less uncertainty for these key stakeholders. For Forsythe Technology, an IT solutions provider with over $1 B in gross revenues, this issue was top of mind when the company’s ESOP purchased the stake of founder Rick Forsythe in 2006. “We are a service business,” says Executive Vice President Al Weiss. “Our people are critical to our success—retaining and incentivizing them is what makes our company thrive. Ownership gives our team a big reason to stay with us and to perform. ” And the proof can be seen in the numbers—turnover at Forsythe is well below industry averages, and the stock price has more than tripled over the last nine years.
Sounds great, but keep in mind that an ESOP sale isn’t right for every business. Good ESOP candidate companies tend to have strong and consistent cash flows—a plus when it comes to servicing any ESOP-related debt and to buying back shares from departing employee shareholders. Yes, that’s right—shares will eventually need to be redeemed, and the sponsoring company must keep this in mind (and analyze periodically with the assistance of an experienced professional), both at outset and on an ongoing basis. Repurchase liabilities down the road may also impact the company’s ability to pursue strategic investments or acquisitions. This is why the strongest ESOP candidates tend to have broad employee shareholder bases with a wide range of retirement dates so that the liability can be spread out over a longer period of time.
An ESOP sale will also trigger governance and information-sharing issues that may well have not existed before. By law, ESOP participants in a closely-held company must be given voting rights on certain major decisions such as mergers, sales, or liquidations. The ESOP trustees have a fiduciary duty to the employee shareholders and will likely want to work with outside advisors to assist with the analysis and help them manage any conflicts that might arise.
To manage expectations and gain the most benefit on the incentive front, ESOP sponsors should be prepared to share regular company financials and performance metrics. . .and to answer tough questions. Al Weiss at Forsythe runs quarterly “Forsythe Forums” to keep employee shareholders current and says these are a key component of keeping everyone on the same page.
If the selling shareholder plans to use the ESOP as a succession plan (i.e. plans to sell most or all of his/her interest and leave active management), there must be a strong management team in place to run the business. All shareholders, including the employees, must have confidence in their leaders’ ability to manage and grow cash flows, both to service the debt and, ultimately, to repurchase their shares, hopefully at a higher price.
Lots to think about. . . Depending on selling shareholder goals, an ESOP sale could be the ideal option, but it’s certainly not the only one. Give us a call at 773 368-4852 to get a conversation started!