Are you considering selling your business? If your business is registered in the United States*, there are many possible exit strategies and among those, an Employee Stock Ownership Plan (ESOP) may seem to be an appealing option. However, it is important to understand the differences between an ESOP and a strategic buyer before deciding.
While there are advantages of ESOPs, a strategic buyer often offers superior outcomes for sellers. In this article, you will learn what an ESOP is, its advantages, and scenarios of when it may not be the best option for an owner.
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What is an ESOP?
An ESOP is an employee benefit plan that allows business owners to transfer ownership to their employees. It provides tax advantages to the company, while employees receive the value of their shares from a trust.
In an ESOP purchase, ownership is transferred by creating an Employee Stock Ownership Trust (ESOT). This trust vehicle, in turn, procures the company at a fair market valuation. An ESOP is controlled by a fiduciary or trustee, not the employees.
Typically, in a standard ESOP transaction, the company has two options: borrowing money from the bank or selling shares to shareholders. In certain cases, a combination of both actions may be employed. Once the necessary funds are obtained, the company extends a loan to the ESOT, providing the seller with payment in exchange for their stock.
Potential Benefits of an ESOP
An ESOP reinforces employee loyalty as the employees have ownership in the company. The arrangement supports the long-term performance of a business since its employees become shareholders who also have a vested interest in the company’s success.
Additionally, an ESOP may be the sole shareholder of a company owning 100% of the stock. If the ESOP owns 100% of a company and it is structured as an S corporation, the company does not have to pay federal taxes while paying down the debt to finance the ESOP transaction. The associated tax savings often fund repayment of the transaction debt, especially if the debt was funded with low-interest rates and corresponding low-interest payments. An ESOP may also let owners sell 100% of their shares while still allowing them to maintain operational control of the business and the same income.
Disadvantages of an ESOP
There are several factors to consider on why an ESOP may not be the right choice for an exit from your business.
1. Lower Valuation: Unlike strategic buyers who often pay a premium above market value, ESOPs follow fair market value and IRS guidelines when purchasing stock. As a result, the valuation in an ESOP transaction can be 30% to 50% lower than what a strategic buyer would offer. It’s important to note that companies with higher multiples will experience a longer timeframe for securing financing and receiving a purchase price than other available exit options. Furthermore, in higher interest rate environments, the cost of debt to the ESOP transaction is higher, which lowers the fair market valuation and increases the risk of the company being able to pay back the loan that funded the ESOP. So, ESOPs are generally less attractive in higher-interest economic cycles.
2. Administration: ESOPs are subject to federal regulations, such as the Employee Retirement Income Security Act (ERISA), which can be complex to navigate without proper guidance. If breaches of fiduciary duties or ERISA violations occur, employees may be led to pursue legal actions against the business.
3. High Costs: The Department of Labor may audit ESOP purchase transactions, and if they find that the ESOP paid too much, the transaction could be unwound, resulting in penalties. For this reason, fair market value is usually at the lower end of the range. There are also fees associated with establishing and managing an ESOP, as professional services are required. Additionally, if an ESOP does not own 100% of an S corporation, the tax advantages are lost because tax will still be due on that percentage of the company’s income.
4. Employee Security: ESOPs require the company to buy back stock from employees as they leave, which burdens the company financially. If the company does not have a steady cash flow and faces financial challenges, or if a tight credit market leads to a company being unable to service the debt, it may negatively impact the security of employees. Furthermore, the ESOP may not buy back the stock from the employees (or make payouts to the employees) until the loan that funded the ESOP is first paid off and the company’s operating cash requirements are met.
5. Operating Control: ESOPs are controlled by a fiduciary or trustee, which can create challenges as employees are no longer responsible for the operational decisions of the ESOP. This can also hinder the future sale or exit of the company, which could have benefited the employees. When a Trustee becomes involved, the Trustee is at the top and oversees the ESOP plan, yearly stock valuation, statements, account balances and ensures compliance. If a future buyer comes in, the Trustee will review the offer to ensure the deal would be in the best interest of employees. The trustee has the power to block a transaction if they feel the offer is not in the best interest of the employees.
6. Less Attractive for Future Acquisition: Companies partially or fully owned by an ESOP may be less attractive for future acquisition by a strategic or financial buyer. First, an ESOP is complex and difficult to unwind, which many buyers do not want to deal with. Second, the ESOP is managed by the fiduciary or trustee, which brings additional complexity and potential conflict in the negotiation and execution of an exit transaction. Lastly, there is a hierarchy of cash flow in an ESOP. Bank and Seller Financing are first in line; company cash flow needs are second, then employees tend to fall lower. The seller and bank notes typically get paid off within 7-8 years.
Selling to a Strategic Buyer
Selling your company to a strategic buyer often results in maximum valuation. The buyer considers the company’s integrated strategic value, which can significantly exceed the fair market valuation of an ESOP by amounts typically ranging from 30% to 100% or more, depending on the strategic value created. Selling to a strategic buyer also allows you to negotiate desired outcomes and potentially provide a better future for your employees and business legacy. Finding the right strategic buyer that best fits the business and employees will create more stability and greater opportunities for the business and employees AND achieve maximum valuation. Additionally, this approach prevents passing the risk of a large loan to your employees. Finally, with proper tax and estate planning with the maximum value obtained from a strategic buyer, the seller can achieve much greater net wealth than with an ESOP.
Despite the benefits of selling to strategics, some companies may not be ready to sell to a strategic buyer. For that reason, performing an in-depth analysis of your business is important before proceeding with an exit strategy.
Look to the Expert Guides on M&A
While ESOPs can be a viable option for some businesses in the United States, it’s crucial to consider their potential drawbacks and limitations. STS President, North American Strategies, Andy Harris, says that selling to a strategic buyer often offers greater financial benefits and allows for more control over the future of your business. “An ESOP can result in a business owner leaving significant money on the table, and it could fall short of delivering the outcomes you wanted from an exit,” Harris said.
Consulting with sell-side M&A experts can help you make an informed decision that aligns with your goals. Our team of expert guides at STS Capital Partners have helped hundreds of owners explore the option of selling their company to a strategic buyer.
If you are a private business owner who is interested in finding more resources on how to prepare for an exit, please visit our Insights & Press page to view our other thought leadership articles.
*Please note that programs and incentives available upon the sale of a business vary by country. The information and guidance provided in this post on ESOPs are specific to businesses registered in the United States.