Does an ESOP Make Sense for My Succession Plan?
As a business owner, you have to make many decisions, including how, and when, it’s time for you to move on from your business. The process of stepping away from your company can be difficult, but proper planning can ensure that you and your business will not only survive the process, but thrive for years to come.
Once you decide that you’re ready to plan for exit, you have to decide exactly how you want to go about the process. There are different routes you can choose, including:
- Sell to the management team
- Transfer ownership to your children
- Sell to a competitor
- Sell to a private equity firm
- Sell to an employee stock ownership plan (ESOP)
Fluctuating around 10,000 total plans in the U.S., employee stock ownership plans (ESOP) can be a viable choice and depending on your business’ situation and structure can offer substantial tax savings, among other benefits. However, ESOPs are not for everyone and careful planning and consideration are required.
Like any big business decision, you need to do your homework on succession planning to determine what’s best for you and your company.
What Makes an ESOP Different
At the most basic level, an ESOP is simply an employee benefit plan (similar to a 401(k) plan) that allows employees to effectively own stock in the company. ESOPs offer special perks, but they can have their downsides depending on what you’re looking for. There’s plenty to learn about ESOPs, so make sure you balance the pros and cons to figure out if they’re the right fit.
ESOPs Offer Financial Advantages
There can be substantial tax savings associated with selling to an ESOP. For example, a C Corporation shareholder that sells at least 30% of their shares to an ESOP can roll over the proceeds into other qualified investments and defer capital gain taxes under the provisions of Sec. 1042. Any potential gain on the sale is deferred until the newly purchased, qualified investments are sold.
The tax benefit of selling stock of an S Corporation are mostly realized by the company as ESOPs are qualified plans and therefore not subject to pass through income taxes. This tax savings can also benefit the seller, as increased cash flow can be used to speed repayment to the seller in leveraged situations.
Another potential tax advantage that can be realized by the company is receiving tax deductions for interest as well as principal repayments on ESOP loans.
ESOPs Work Best for Certain Companies
The size of the company does matter for an ESOP. You need to have a reasonable size, workforce, and payroll to be able to support an ESOP. Due to administrative cost and anti-abuse rules, it would be difficult for business worth less than $2 million with less than 20 employees to be a feasible ESOP.
Additional characteristics that make a ESOP candidate include a good history of cash flow, solid successor management teams, debt capacity, relatively low employee turnover and a business that is not overly cyclical.
ESOPs Help Owners Have a Say
One of the main advantages of an ESOP is that it allows you to protect your business and your legacy. If you sell to an outside party, they typically want to buy control. Passing on control allows the buyer to have free reign to do whatever they want with your company, which could include changes to the workforce and irrevocably changing the foundation that you built. You will also have a boss.
You can structure the transition so that you still have some level of control and/or involvement in day-to-day operations. One potential way of doing this is selling shares to an ESOP in steps. This would include not selling 100% of the business up front and playing a role while you phase yourself out of the company. In a few years, you can sell additional shares and create your own pace for departure.
Alternatively, you could sell 100% of the Company to an ESOP, but retain a seat on the board. The general idea is having the ESOP as the owner allows for greater flexibility in how and when you transition out of the business.
ESOPs Rewards Employees
When you choose to exit your business through an ESOP, it basically gives your employees ownership of your business. As such, it creates a stock-based incentive oriented retirement program that can help retain and empower your workforce.
Since an ESOP involves your employees, it’s critical that they buy in to the process for long-term success. This can be a challenge because you may present this to employees and they may not understand how an ESOP works. Good communication and a receptive workforce can be a key part of the ESOP process.
Selling your business can take a while, regardless of who you sell to. A typical transaction can take six to nine months. We suggest starting the succession planning process three to five years before you actually want to sell your business.
Whether you decide an ESOP is right for your business or want to use a different exit strategy, you’ll want to find a firm that can help you prepare for the future. Apple Growth Partners has business valuation and/or tax planning associates who can help guide you and your business through the succession planning process. Contact us when you’re ready to talk about a succession plan that makes sense for your business.