At our most recent Valuation, Forensic, and Litigation Support (VFLS) Quarterly Briefing, my colleague Billy Robinson and I spent our time on a subject that generates a lot of questions from the business owners we work with: employee stock ownership plans, or ESOPs, and how they can serve as a strategic option for both business transition and employee engagement.
Billy and I spend a lot of time serving ESOPs, and we are both members of The ESOP Association, the National Center for Employee Ownership, and other ESOP organizations. He led off the session with the basics. For those of you who already have ESOP experience, some of this may seem basic, but my hope is that it gives everyone a useful foundation.
I like to start with the numbers behind succession planning, because they paint a challenging picture:
The takeaway: selling a privately held company is not as easy as a lot of people think it is.
We asked attendees where their organization, or a business owner they advise, stands in the succession planning process. The responses closely tracked the national statistics:
That 20% with a comprehensive plan is really good to see. But it is no surprise that, combined, roughly 64% of respondents either have no plan or have discussed one without putting it in writing.
Every business will go through a transition at some point, and when you think about it, there are really only a few options. You can sell the company. You can transfer it to members of management, family, or others. Or, and this is a pretty common option, the business closes, sells off its assets, and everybody goes home.
Unlike publicly traded companies, private businesses have no ready market for finding a buyer. It generally requires brokers and identifying potential acquirers. There is a lot of private equity activity today, and that has changed things somewhat, but it is still difficult for private companies to transition or sell.
That is why I believe the approach to any business transition should be based on shareholder goals, in the context of achievable alternatives, and after considering all of the options. Those options include:
When evaluating liquidity options, you need to focus on calculating after-tax proceeds, because the way a deal is structured can significantly change the tax outcome. We spend a lot of time planning with clients on exactly this point, and an ESOP can help you maximize after-tax proceeds. An ESOP also lets you control the timing of succession and transfer, which I think is an important component of any orderly transition. Other goals to weigh include the selling shareholder’s ongoing role as an executive, diversification of personal wealth, and legacy.
On diversification, I met with a prospect the day before our briefing whose seller had done an ESOP. The reality was that he did not have much wealth outside of his company; it was all tied up in the business until the ESOP transaction. That transaction diversified his risk and his investment portfolio as he neared retirement age. And shareholders are often worried about their legacy, as they should be. It is an important part of any consideration.
ESOP stands for employee stock ownership plan. Here are its defining features:
I find it helpful to look at the same structure from three angles. To business owners, an ESOP is a buyer of their stock. To employees, it is a company-funded retirement plan whose value at retirement depends on the value and performance of the stock. To companies, it is a tax planning and succession planning strategy, but very much a corporate finance technique that helps take the business to the next generation of leadership.
As of 2023, approximately 6,600 ESOPs existed in the United States, covering 15.1 million employees. A few other figures worth knowing:
For the company. An ESOP separates the transition of ownership from the transition of management, which provides greater continuity than a typical change in ownership. To be clear, management succession planning still has to happen in an ESOP. The company may deduct its ESOP contributions, reducing its tax liability, and it can repay transaction debt with pre-tax dollars. If you are an S corporation that is 100% ESOP-owned, there is essentially no tax obligation to the IRS, although you may still owe some franchise and excise taxes to states. And lots of studies have shown that ownership motivates management and employees.
For management. ESOP contributions and allocations are based on pay, so more highly compensated employees are better rewarded, creating a meaningful wealth-building opportunity and recognition for service. In the construction space, I have seen lots of blue-collar workers retire as millionaires or multimillionaires simply because of their longevity with the company, along with the performance of the stock. An ESOP also allows a gradual, orderly transition and, in theory, should increase productivity.
For employees. Employees get to participate in the equity appreciation of the company and receive retirement benefits at no cost to them. The ESOP can be combined with other benefit plans, and required annual valuations provide transparency into value and vesting. That valuation work is something I do a fair amount of.
For the seller. Nobody says a seller has to go away; you can stay involved in management if you want. C corporation (not S corporation) sellers may be able to defer capital gains indefinitely by electing Section 1042. Seller financing, which is pretty common in these transactions, can provide attractive cash flow and tax flexibility. You can sell as little or as much as you want, although there is a 30% minimum for certain tax benefits. We have lots of clients that are partial ESOPs and will continue to be forever, and a partial ESOP can be a way to dip your toes in the water.
I also want to address a common misconception: that with an ESOP, you are not going to get paid. You may not get paid as much as a strategic buyer trying to bolt you on would pay, but you can still get a fair value. These valuations are based on fair market value as determined by valuators, and you may receive fair market value for your shares. And if you have no other ownership transition alternatives, an ESOP can deliver a greater return than liquidating, while also creating a meaningful legacy.
ESOPs are tax efficient, and they offer a shareholder- and company-directed process in which you control timing and legacy. But I want to be candid about the disadvantages. ESOPs can be complex. They are very much regulated and scrutinized by the DOL and IRS, and there has been a lot of class action litigation in the ESOP space. They also often involve seller notes, so as a seller you still have some skin in the game and depend on the company earning enough each year to fund contributions and pay down the debt. If you are a successful company, the tax advantages make that easier.
Q: Since employees don’t actually own the shares in the ESOP, are there no tax implications until they retire or leave and cash out?
A: That’s correct. Company contributions are generally tax-deductible to the company, which matters particularly for a partial ESOP, but employees are not taxed on their shares until they retire and begin receiving distributions from the plan. At that point, it is treated very similarly to withdrawing funds from a 401(k). Employees receive a Form 1099-R and are taxed at that time.
Q: Can an owner sell a portion of the company to one individual and set up an ESOP for the balance?
A: Yes, selling to another shareholder is an option, but you don’t get the same tax advantages on that portion. An ESOP is for the collective employee group rather than an individual. A follow-up asked whether an owner could sell 51% to an individual and 49% to an ESOP. That is very much possible.
Q: What is the reason for the litigation? Is it related to valuations?
A: Oftentimes it is. The claims are generally that the ESOP’s trustees breached their fiduciary responsibility to the retirement plan, usually around valuation, such as overpaying for the company. There are class action litigators who look through Form 5500 filings to find ESOPs and potential class participants, and then file a suit. But if you do it right, hire a good independent trustee, and hire a really good valuator, you should be protecting yourself from those risks. There are certainly ways to manage them.
Q: Can an employee sell their shares at any time, or only at retirement or when leaving the company?
A: No, participants can’t simply decide they are done holding their shares. Once a participant reaches age 59½, there may be diversification opportunities if the plan allows for it, but typically shares are only liquidated upon death, disability, retirement, or separation from the company.
We closed this portion of the session with a poll asking how likely attendees, their organizations, or their clients are to evaluate a business ownership transition within the next three years. Given the statistics above, it is a question worth asking now rather than later. If you would like to explore ESOPs more deeply, we would be happy to jump on an exploratory call to talk through how they work and learn more about your organization.