Why Selling to an ESOP Often Provides the Highest Financial Benefits

Most owners who sell to an employee stock ownership plan (ESOP) are focused more on legacy and values than price. They have spent much of their lives building a great business and want to see the people who have helped build it carry it forward. Other owners, however, want to consider all their options and may be concerned that selling to an ESOP means giving up significant value. They may have heard that selling to an ESOP means giving up some of what they could get by selling to another buyer. A new NCEO paper coauthored by NCEO founder Corey Rosen and by Regina Carls and Eric Zaiman of J.P. Morgan, How Proceeds from ESOP Sales Compare to Those from Other Buyers (PDF; also see the embedded version below), shows that selling to an ESOP can often match or exceed the financial benefits from selling to another buyer.

An ESOP is essentially a financial buyer that can often match an alternative financial buyer’s price. Individual investors and private equity firms are typical examples of financial buyers, although some private equity firms may offer a synergistic price, depending on their other holdings. But a common misconception is that selling to a strategic buyer will always be more financially fruitful for the owner compared to selling to an ESOP. Although that can be true in some cases, many sellers find that ESOP transactions can produce comparable, or even better, proceeds than selling to all but the most aggressively priced buyers, especially once you factor in transaction costs, taxes, and financing terms.

There are a few reasons for this. First, buyers who are willing to pay a higher price are less common than many owners think. Based on what experts in the field have told us, about 20% of ESOP companies could get a significantly higher price. These offers often come with contingencies such as earnouts, however, that add uncertainty and risk to the final price. Second, sellers to an ESOP can defer taxation on the gains from the sale by reinvesting in stocks and bonds of other companies. The company must be or convert to C status, and the ESOP must own at least 30% of the stock take advantage of that tax deferral. Finally, many ESOP transactions are financed with a seller note. These notes can be priced at rates above senior debt. Many sellers tell us they prefer this approach to selling even at a higher price to an outside buyer and investing in a relatively safe but lower-yielding portfolio. Sellers can also choose to take a lower interest rate in exchange for warrants with the same present value as the foregone interest. Warrants give the seller the right to buy shares in the company for some number of years into the future. If the company does well, these warrants can be cashed in. That may provide a better all-in return than even a sale to a synergistic buyer, though each type of sale carries different levels of risk.