As many private company owners struggle with the transition of their businesses, Employee Stock Ownership Plans (ESOPs) represent an ever-increasing option. One reason is because an ESOP can satisfy many of a private company owner’s transfer motives, providing a number of advantages that are in sync with the common personal and financial motives of the owner. In this article, we will explore these advantages.
- Individual Tax Efficiency: If a company is a C corporation when shares are sold to an ESOP, as long as the ESOP owns at least 30%, the selling shareholder can defer the federal capital gain tax on the transaction by rolling over the proceeds into a type of security called a “qualified replacement property” (QRP) after the sale. Currently, the Commonwealth of Pennsylvania does not allow this benefit.
- Corporate Tax Efficiency: If an S corporation has shares that are owned by an ESOP, there is no federal (and often, state) income tax due on the ESOP’s share of the income. An ESOP is a qualified employee benefit plan under ERISA, which makes it a tax-exempt entity. Additionally, for C corporations, contributions and preferred stock dividends paid to the ESOP are tax deductible by the company and are the source of funds to repay debt used to finance the ESOP transaction. This has the effect of giving the company the ability to repay principal on debt with pre-tax dollars which is very tax efficient.
- Ability to Generate Liquidity While Maintaining Control: Owners selling to an ESOP do not need to sell 100% of their stock; they can sell a minority interest. This allows the owner to take some money off the table while still maintaining operating control of their company.
- Owner’s Ongoing Role in the Business: With most other transition options, the transfer of the ownership in the company also means a transfer of the leadership. An owner may need a transition strategy, but may not be ready to exit from the day-to-day activities of the business. Selling to an ESOP affords an owner the ability to exit from the day-to-day at their own pace and on their own time schedule.
- Selling and Still Being an Owner: If the company is an S corporation, the shareholders who sell their stock to an ESOP and continue to work at the company can be allocated ownership shares within the ESOP (within certain limitations), along with the rest of the employee owners.
- Rewarding Employees: Taking care of their long-time, loyal employees is often a goal for owners considering an exit strategy. An ESOP offers a way to reward your people by providing them with a long-term ownership incentive plan for their retirement as well as more job stability, because the company has not been sold to a third party.
- Community/Job Creation: ESOP companies tend to remain in the communities in which their business were built. This is in contrast to companies that are sold to third parties which often move, resulting in lost jobs in the community. ESOPs keep people employed in the communities in which they live.
- Gradual Leadership Succession: Since a sale to an ESOP does not require an automatic change in management and leadership, companies can continue to work on their succession plan before and after the ESOP transaction. This flexibility allows many companies to complete a transaction while continuing to work on the management succession.
- Better Results and Performance: Data tells us that when employees are given ownership, it positively impacts their behavior because they now have “skin in the game.” Generally speaking, an ESOP company’s performance increases over time because its 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.
- Share Value Increases: The improved performance that results from a motivated workforce often manifests itself over time in increased share prices. Generally, ESOP valuations are more typical of a “financial buyer” than a “strategic buyer.” An exiting owner who only sells a minority stake and maintains ownership that they plan to sell over time may benefit from an increased share value due to improved performance.
- Acquisition Advantages: An ESOP can make acquisitions far more attractive because of their tax advantages. An ESOP can be attractive to a selling company if it is a C corporation because the selling shareholders have the ability to defer income taxes on the sale if they elect to roll over the proceeds into qualified replacement property (see #1 above). Additionally, the ESOPs acquisition debt can be repaid effectively in pre-tax dollars because of the tax deductions available for contributions to the ESOP (see #2 above).
- Improved Recruiting and Retention: We all know how expensive it is to recruit and retain people and turnover is one of the biggest hidden costs for any company. ESOPs typically have better retention rates because of the long-term benefits associated with the ESOP. An ESOP is also an attractive recruiting tool since it offers an employee benefit that is not available in many other companies.
- Differentiation from Competitors: ESOP companies often have uniquely positive 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 suppliers. Additionally, customer and supplier relationships with ESOP companies are often viewed as more stable because the business is unlikely to be sold to a third party. Over time, this can become a competitive advantage.
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