Myths and misconceptions prevent many owners of closely held businesses from considering selling their companies through an employee stock ownership plan (ESOP). For many such owners, ESOPs have advantages in terms of tax, financial, and intangible issues that no other transaction method can offer. This book is designed to educate owners, managers, and advisors of closely held businesses on selling to an ESOP. It describes how ESOPs work and what the basic rules are; how valuation works in an ESOP transaction and during the ongoing operation of the ESOP; financing and feasibility; and the tax-deferred Section 1042 rollover for selling owners. Armed with this book, you will be able to make a more informed decision about selling to an ESOP.
The 11th edition updates and reorganizes the material as of 2020 to reflect the current legal, valuation, and investment environment that companies and their owners will face as they evaluate and negotiate ESOP transactions. A new chapter at the end compares an ESOP sale to other exit strategies.
Table of Contents
1. Should You Sell to an ESOP?
2. Understanding ESOP Valuation
3. Financing the Leveraged ESOP
4. ESOP Feasibility
5. Investing After You Sell Your Business to an ESOP
6. Alternatives to Selling to an ESOP
About the Authors
About the NCEO
From Chapter 1, "Should You Sell to an ESOP?"
The good news for owners who do want to sell to an ESOP, and whose companies are the right fit, is that good intentions can be rewarded with significant financial advantages. For the large majority of companies, selling to an ESOP is a better deal for sellers than selling to outside buyers, even when they offer a premium. Some of the major financial benefits are listed below:
- Tax deferral of capital gains: When owners of C corporation shares meet specific requirements in connection with selling their shares to an ESOP, they may defer capital gains taxes and possibly avoid them entirely if the qualified replacement property they buy with the proceeds of the ESOP sale becomes part of their estate. A more detailed explanation of these rules is in the next section.
- Partial sales: Most private investors are not willing to buy partial stakes in private companies, while an ESOP is well suited to a partial sale or a series of sales that culminate in the original owner selling his or her entire ownership interest.
- Using pretax dollars: ESOPs are the only way the company can use pretax dollars to buy out current owners. If a company buys shares back from an owner outside of an ESOP, it will need to use after-tax dollars. Any buyer other than the company will also be using cash on which tax has already been paid, effectively increasing the cost to the buyer. If a seller will be retaining partial ownership of the company, this tax benefit will increase the value of the seller’s remaining shares. In many cases, the ESOP sale will yield a comparable or better after-tax return than other sales, especially when all contingencies are considered.
- S corporation tax shield: When an S corporation sponsors an ESOP, a portion of its income is no longer subject to federal income tax. So if an owner of an S corporation sells part of the ownership to an ESOP, the company will pay lower taxes going forward, enhancing future profits. A 100% ESOP-owned S corporation pays no federal income tax, so if an S corporation becomes 100% ESOP-owned and the sale to the ESOP is seller-financed, the seller’s likelihood of repayment will be higher than in the case of a 100% sale to an ESOP in an equivalent C corporation.
From Chapter 3, "Financing the Leveraged ESOP"
Most successful ESOPs result from successful companies. Strength of cash flow emanates from a sound operating model and good financial information. To analyze the effects of an ESOP loan on the company, advisors tend to look for good historical trends of profitability and cash flow. More importantly, one should study realistic projections of the company and its profitability during the course of the loan’s amortization period. Projections can be difficult to rely upon; however, most companies can project the next two years’ performance with some reliability. Because the ESOP loan, which represents nonproductive debt, is being put in place, the debt service coverage that most lenders look for would be in the range of 1.25 to 1.75 times cash flow. This is an indicative range. Some aggressive lenders may agree to a lower multiple for the first two years of the loan and establish a provision for a larger cushion over time.
Last but not least, because this is nonproductive debt, the company needs to satisfy its ongoing working capital and capital expenditure requirements. Thus, the company must have access to further credit if it cannot finance growth internally. The key is to structure a deal that will allow the company to continue to grow despite the addition of ESOP debt. The combination of understanding historical trends and future projections, along with adequate debt service coverage and access to additional credit, are important factors in structuring an ESOP loan that will not “kill” the company.
From Chapter 4, "ESOP Feasibility"
33. Will there be additional stock-based or synthetic equity incentives for management? If so, will such incentives take the form of stock options, a stock bonus, a stock purchase plan, stock appreciation rights (SARs), restricted stock, or a combination of one or more of the above? Frequently, an ESOP is paired with one or more of these equity-based incentive plans to maximize equity incentives for key employees, with stock appreciation rights being used most frequently in S corporation ESOPs. Will any of these incentives create a failure of the anti-abuse provisions under Code Section 409(p) and the regulations issued by the IRS related to S corporation ESOP companies? See question 57 below.
From Chapter 5, "Investing After You Sell Your Business to an ESOP"
To help John and Jane evaluate the trade-off between paying the tax and electing to take the 1042 deferral, we project their wealth under both scenarios. In each case, the 64-year-old couple has $1 million in liquid assets, including $600,000 in a 401(k); they sell 100% of the business to an ESOP for $10 million; they have $0 cost basis in the stock; and they want to spend $225,000 per year after taxes.
In Scenario A, they pay the capital gains tax on the sale and reinvest the proceeds in a portfolio with 40% in stocks and 60% in bonds. In Scenario B, they use the proceeds of the sale to purchase $10 million of FRNs with an average coupon of LIBOR minus 0.3%, and they use the FRNs as collateral to borrow $9 million at an interest rate of LIBOR plus 0.9%, for a 1.2% cost of carry. They reinvest the $9 million from the loan in a portfolio with 40% in stocks and 60% in bonds.
Table 5-3 shows that in either scenario, John and Jane are likely to increase their liquid wealth, even after spending from the portfolio for the next 30 years. If they decide to pay the capital gains tax on the company sale, we project that they will accumulate $9.0 million in typical markets. If markets are hostile, we project that there is a 90% chance that John and Jane will have at least $2.9 million remaining at age 94.
But the active 1042 reinvestment strategy offers a clear advantage. We project that in 30 years, John and Jane will accumulate $13.1 million in typical markets and $5.1 million in hostile markets. Both outcomes are more than 40% higher than the related projection for paying tax now.
To put this in perspective, we calculated the pretax sale price John and Jane would need to negotiate today in a taxable sale in order to accumulate $13.1 million in 30 years (the same wealth achieved by selling to the ESOP). We estimate that they would need to sell the company for $11.9 million before taxes, or 19% more than the $10 million the ESOP would pay, to achieve the same wealth in 30 years.
From Chapter 9, "The 2015 ESOP Transaction Survey"
There is a clear relationship among respondents between the number of services procured and the total cost of the transaction, as shown in figures 9-5a and 9-5b. For initial transactions, a majority (56%) of companies procuring only one or two additional services beyond valuation reported a total transaction cost of under $75,000, while just 19% of those procuring three or more additional services reported transaction costs under $75,000. For subsequent transactions, a large majority of companies (78%) reported transaction costs under $75,000 when procuring one or two additional services, compared to 21% who reported transaction costs under $75,000 when procuring three or more additional services.
Most smaller transactions (in which the company moved to less than 10% ESOP-owned) fall into the smallest cost category, as shown in figure 9-6.