As many baby boomer business owners look to exit their businesses over the next decade, it is important that they understand the array of potential options. One of those options is selling to an Employee Stock Ownership Plan (ESOP).
An ESOP is a qualified defined contribution plan that provides employees with ownership in the company and can create alignment between the entity and its employees. Selling to an ESOP is one mechanism for business owners to exit their business while simultaneously rewarding employees.
ESOP transactions are complex and getting the many details right is imperative. Below are some potential advantages and disadvantages of an ESOP transaction:
Some advantages include:
- If the corporation has elected S corporation status, it can avoid federal and state income tax proportionally related to the percentage of the company that is owned by the ESOP.
- Selling the business to existing employees may increase retention, morale and improve the company culture.
- Potential “second bite of the apple” in the form of warrants for the original owner(s).
- Original owner(s) has discretion to sell only part of their business and consequently, help reduce their concentration risk.
- Business must be valued by an independent third party to establish fair market value. This allows selling shareholders to sell the business to the ESOP and potentially realize a higher value than in a non-ESOP sale to existing employees.
- If the business is a C corporation, the selling shareholders will have tax deferral opportunities with the proceeds from the transaction.
Some disadvantages include:
- Cultural challenges can arise due to most employees’ newfound ownership.
- The ESOP will typically take on a substantial amount of debt in the form of a bank loan and seller financing which can limit operational flexibility. Strong and predicable cash flows to pay down debt are an important consideration.
- Administrative responsibilities and costs dramatically increase for the company, typically.
- Can be a complex and confusing process. When selling to an ESOP, it is important to have the right team in place to guide you through the process. Typically, this team would include a CPA, Financial Advisor, Valuation Firm, ESOP Attorney and an Investment Banker.
- Tax deferral opportunities are not right for everyone. These opportunities can be complex and require an experienced advisor to help inform your decision.
Choosing how you want to sell your business is a complicated and emotional decision. Before you select a specific path, it is important to thoroughly understand your options, including how it impacts you as the selling shareholder(s) and how it will affect your company post-transaction.
This content is for informational purposes only and does not constitute financial, tax, or legal advice. Please consult with qualified professionals for personalized advice regarding your specific situation.