For companies that are C corporations before the ESOP, there are significant opportunities to defer the gain on the sale of shares by the owner. For S corporations, the company pays no federal income tax on the ESOP’s share of the net income after the ESOP is in place.
While these are big advantages to the ESOP exit strategy, there are other significant benefits to consider:
- Ability to generate liquidity while maintaining control. Owners selling to an ESOP do not need to sell 100 percent of their stock. They can sell a minority interest - as little as 30 percent. This allows the owner to take some money off the table while still maintaining operating control of the company.
- Better results and performance. Data tells us that when employees are given ownership, it changes their behavior because they have skin in the game. Generally speaking, ESOP company performance increases over time because the employees are more engaged and productive. Knowing that they will share in the benefits of the company’s increased performance is a powerful motivational tool for employees. Business owners may want to consider this motivating insight as an add-on value for embracing an ESOP exit strategy.
- Improved recruiting and retention. We all know how expensive it is to recruit and retain people. Turnover is one of the biggest hidden costs for any company. ESOP companies have much better retention rates because of the long-term benefits associated with the ESOP. It is a very attractive recruiting tool since it offers an employee benefit that is not available in many other companies.
- Share value increases. The improved performance that results from a motivated workforce manifests itself in increasing share values over time. Generally, ESOP valuations are more typical of a “financial buyer” than a “strategic buyer.” However, if the exiting owner only sells a minority stake and maintains ownership that they plan to sell later, there is often an opportunity for the later share values to be much higher than the initial transaction due to the improved performance.
- Differentiation from competitors. ESOP companies have unique cultures because of their employee ownership. These differences become visible to the market and can serve as a point of differentiation in the way the company interacts with its customers and prospects. Over time, this can become a competitive advantage.
We are seeing an increased interest in the viability of the ESOP exit strategy. If you are considering one, take into account the broad array of advantages beyond taxes.
Mario O. Vicari is a director with Kreischer Miller and a specialist for the Center for Private Company Excellence. Contact him via Email to discuss an ESOP exit strategy for your organization or other business exit planning matters.
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