It may be more practical than you think
One of the biggest challenges for owners of closely held businesses is finding a way to turn their equity in a business into cash for retirement or other purposes. The decision to sell is more than an economic one, however. After putting years into a business, an owner develops a strong attachment to the company. At the same time, the owner often has a sense of loyalty to the employees and would like to see them maintain a continuing role in the company. And, as baby boomers retire, this issue will be one that more and more business owners will be forced to face.
For some business owners, the answer to these problems will be to turn over the company to an heir or sell to a competitor. But many owners do not have heirs interested in the business, and outside buyers are not easy to find. Even if they can be found, they may want to buy the company for its customer lists, technology and facilities. Or, they may simply want to put a competitor out of business. Furthermore, these sales usually come laden with all kinds of contingencies (such as earn-outs) that may make them much less appealing than they initially seem.
Selling to employees can provide an answer, but many business owners assume it’s not practical. After all, where would employees get the money? It’s a valid concern. But there is, however, a very practical alternative for many companies: an employee stock ownership plan (ESOP). ESOPs are funded out of the taxdeductible future earnings of the company, not by the employees. In addition to the substantial tax benefit, ESOPs can provide additional benefits to sellers, companies and employees. They can be used to buy all or part of a company, or to buy out just one owner when there are multiple owners. ESOPs will not work for every company, but for companies that are profitable and have at least 10-15 employees, they deserve a closer look.
Selling directly to employees
First, let’s take a look at how a company might be sold directly to employees. Essentially, the employees buy the company outright out of their own after-tax assets— this usually calls for substantial personal borrowing. These kinds of sales are unusual because of the considerable cost and risk involved. The employee money is after tax and is treated as a capital gain to the owner. Typically, employees buy the shares year by year, either out of their own after-tax dollars or foregone bonuses. Again, this is a capital gain to the seller.
If employees don’t have the assets, and the owner wants to sell a large share of ownership more quickly, the transaction is usually done through an installment sale. The seller takes a note that is repaid by the employees with interest over time. If cash flow from the business is used to repay the note, principal is not tax deductible to the company. The interest may or may not be deductible. If the employees pay the note, it’s out of the after-tax dollars, and the sale can be structured so that the seller takes capital gains tax treatment. There are a number of issues in installment sales, such as the interest rate determination, the structure of the promissory note, contingencies on their use of corporate cash, the role of the seller going forward and security for the note.
Regardless of how the sale is financed, another approach is to structure the sale partly as a lease of assets (tangible or intangible), so that the company itself, not the employees, can make the purchase in deductible dollars. In this way, the seller pays ordinary income taxes. Also, part of the sale may be some combination of an employment agreement, non-compete agreement and/or payment for services in the board. The sale may also include some kind of earn-out or similar provision as part of the sale price so that what the owner ultimately gets depends on how the company performs.
ESOPs were specifically created by Congress to be the most tax-favored way a closely held business owner can sell shares. For the owner of a C corporation, proceeds on the gain from the sale to the ESOP can be tax deferred by reinvesting in the securities of other domestic companies. If these securities aren’t sold prior to the owner’s death, no capital gains tax is ever due. If the company is an S corporation, LLC or partnership, it can convert to a C corporation before the sale to take advantage of this tax deferral. If the company remains as an S corporation, the owner does pay capital gains tax on the sale, but reaps all the other benefits of selling to an ESOP. The most important of these benefits is that the owner’s shares are bought in tax-deductible dollars, either from company contributions or plan borrowings. The sale can be all at once or gradual, for as little or as much of the stock as desired. For the employees, no contributions are required to purchase the owner’s shares. The owner can stay with the business in whatever capacity he or she desires. The plan is governed by a trustee, but since the board appoints the trustee, changes in corporate control are usually nominal unless the plan is set up by the company to give employees more input at this level.
An ESOP is a kind of employee benefit plan, similar in many ways to qualified retirement plans and governed by the same law (the Employee Retirement Income Security Act). ESOPs are funded by the employer, not the employees. Stock is held in a trust for employees meeting minimum service requirements and allocated to employees based on relative pay or a more level formula over item, then distributed after the employee terminates. ESOPs cannot be used to share ownership just with select employees, nor can allocations be made on a discretionary basis.
Financing an ESOP
The simplest way to use an ESOP to transfer ownership is to have the company make tax-deductible cash contributions to the ESOP trust, which the trust then uses to gradually purchase the owner’s shares. Alternatively, the owner can have the ESOP borrow the funds needed to buy the shares. In this way, larger amounts of stock can be purchased all at once, up to 100 percent of the equity. Normally, the bank will loan to the company, which then reloans to the ESOP, not necessarily on the same terms. In some cases, such as when the total debt exceeds current book value, the bank may also want a personal guarantee, or it may loan only part of the total sought. In that case, the ESOP would buy a portion of the shares now and a portion after some of the debt has been paid.
The owner can also take back a note— an approach that is increasingly common. The tax deferral on the sale requires the purchase of special long-term bonds. Many sellers decide to pay just the 15 percent capital gains tax now. Meanwhile, they get an interest rate that reflects the risk of the loan (currently six percent to 10 percent per year), plus they get the capital gains from the sale. However the money is obtained, the price is set by an independent appraiser, as discussed below.
Compare the ESOP buyout to two other common methods of selling an owner’s shares: redemption or sale to another firm. Under a redemption, the company gradually repurchases the shares of an owner. Corporate funds used to do this are not deductible. A $3 million purchase in a redemption might require more than $5 million in profits to fund once taxes are paid. Moreover, the owner must pay tax on the gain at capital gains or dividend rates. In a sale to a C corporation ESOP, the money made is considered a capital gain, not ordinary income, and taxes can be deferred. Even more important, the company only needs $3 million to fund the $3 million purchase—a factor that also applies to sales to ESOPs in S corporations.
Or, consider the second alternative: selling to another company or individual. In a cash sale, taxes would be due immediately. If the sale is for an exchange of stock in the acquiring company, taxes can be deferred until the new stock is sold, but 80 percent of the company must be sold all at once, and the owner ends up with an undiversified investment for retirement.
The price the ESOP will pay for the shares, as well as any other purchases by the plan, must be determined at least annually by an outside, independent appraiser. The appraiser’s valuation will be based on several factors, most importantly the discounted projected future earnings of the company. The appraiser is assessing what a financial buyer would pay, one who would operate the business as a standalone entity. A strategic buyer, such as a competitor, by contrast, might pay an additional premium because when the target company is acquired, there are perceived operational synergies that make the target more profitable to the buyer than it would be as a stand-alone entity. The ESOP cannot match this price because it cannot generate these synergies.
How employees get stock
ESOPs are much like other tax-qualified retirement plans. All employees who have worked at least 1,000 hours in a plan year must be included. They receive allocations of shares in the ESOP based on relative pay or a more level formula. If there is an ESOP loan, the shares are allocated each year based on the percentage of the loan that is repaid that year. The allocations are subject to vesting for as long as six years. Employees do not receive a distribution of shares until they terminate, and then the distribution can be delayed for five years for reasons other than death, retirement or disability. The plan is governed by a trustee appointed by the board, and employees have very limited required voting rights (they don’t have to elect the board, for instance), although companies may provide additional rights.
S corporation ESOPs
If a company is an S corporation, the profits attributable to the ESOP are not taxable. So if the ESOP is a 30-percent owner, income taxes are not due on 30 percent of the profits. If the ESOP is a 100-percent owner, no taxes are due—a rule that has led to the rapid growth of 100-percent S corporation ESOPs, often conversions from C corporation companies with ESOPs after they make the final purchase of shares.
Making the decision
ESOPs may sound appealing, but they’re not right for every company. Several factors must, at a minimum, be present:
- The company makes enough money to buy out an owner. The company must be generating enough cash to buy the shares, conduct its normal business and make necessary reinvestments.
- Payroll must be adequate to cover the purchase. Because there are some limits (albeit generous ones) on how much can go into the ESOP each year, if a business has an exceptionally high value relative to its payroll, it may not be a good ESOP candidate, although this is an unusual scenario.
- If the company is borrowing to buy the shares, its existing debt must not prevent it from taking out an adequate loan. Similarly, the company must not have bonding covenants or other agreements that prohibit it from taking on additional debt.
- If the seller wants to take the tax-deferred rollover, the company must be a regular C corporation or convert from S to C status. S corporations can establish ESOPs, but their owners cannot take advantage of the tax-deferred rollover described above.
- The seller(s) must be willing to sell their shares at fair market value, even if the ESOP pays less than an outside buyer would. An ESOP will pay the appraised fair market value based on a variety of factors, but sometimes an outside buyer can pay more for a company if it has a particular fit creating synergies that go beyond what the company is worth on its own.
- Management continuity must be provided. Banks, suppliers and customers will want to know that the company can continue to operate successfully. It’s essential that people be trained to take the place of departing owners to assure a smooth transition.
To find out if an ESOP is right for your company, create an initial business plan, factoring in legal costs, the costs to buy the shares and the company’s cash flow. If the plan looks encouraging, talk to an accountant about your figures and look into getting a business valuation performed. Your valuation specialist will tell you how much your stock is worth and should also give you a more detailed idea about the practicality of selling these shares. If it looks like an ESOP will be right for you, hire a qualified ESOP attorney to draft your plan. As you consider an ESOP, find some other ESOP company executives to talk to, attend an ESOP meeting or two and finalize your plans with all the key players.