Considerations When Determining Whether an ESOP Makes Sense for You
Selling your business while keeping the business operating smoothy and making sure long-term employees are happy and well taken care of may sound like an impossible task — but it doesn’t have to be. If you’re looking for a way to transition ownership without uprooting the foundation you’ve built, an employee stock ownership plan (ESOP) might be worth considering. ESOPs are a versatile exit strategy that’s ideal for businesses of many sizes, and they can offer a streamlined, effective approach to handing over the reins. But like any major decision, there are both pros and cons to consider.
Let’s dive in and see whether an ESOP might be the right fit for your business — and for you.
What is an ESOP?
In simple terms, an ESOP is a qualified retirement plan with a few important twists. Unlike your typical 401k, which helps employees save for their retirement, an ESOP lets employees buy into the company while building their retirement nest egg. As a result, an ESOP can be a powerful way for the owners of a privately held company to gradually (most common) or quickly (less common) transfer ownership to their employees. It could be a way to exit without needing to find an external buyer and dealing with nonstop negotiations.
For business owners, an ESOP can be a powerful way to retain control during the transition period (if desired) while also reducing the tax burden of the sale. It’s not just about selling your company — it’s about creating a legacy and helping to ensure continuity for both your employees and customers. And to incentivize you to help your employees save, the ESOP may provide dramatic tax benefits to you (the seller), the business and the employee participants.
Benefits of exiting a business using an ESOP
When executed properly with a well-equipped team, an ESOP has the potential to contribute significantly. Below are several reasons why you might consider this path.
Seller benefits
- You’re in charge: You have more control over the transition, making sure it unfolds at a pace and in a manner that suits you.
- Fair market value: The process is structured to help ensure you get a fair price for your company. Generally an ESOP provides a reasonable price, although the price may be somewhat lower than what could potentially be found from an interested third-party buyer.
- Greater stability: ESOPs help maintain business continuity so that your employees can continue providing the excellent service your clients or customers expect. This continuity may lead to improved results over time, as the seller may choose to sell a portion of the company now and more as the company continues to grow, offering sellers more and bigger bites at the apple down the road.
- Tax benefits: ESOP sellers may be able to defer their gains completely through what is known as a Section 1042 rollover transaction, assuming certain requirements are met. The tax deferral possibilities on sale proceeds may be beneficial for those in high tax states or those dealing with larger amounts.
- No external buyer needed: Forget about the stress of finding a buyer who “gets” your company — your employees are your buyers. Generally you’ll need a decent sized team to make this work, but ESOPs can be successfully executed with fewer employees than you might suspect (15-20 is a good ballpark).
Employee benefits
- Ownership at no upfront cost: Employees can gain an ownership stake without having to reach into their pockets, as the purchase is funded through profits from the company.
- Better retirement benefits: The ESOP boosts their retirement savings, adding a nice cushion for the future.
- Incentives to succeed: With a stake in the business, employees are more motivated to work hard knowing their efforts directly impact their financial future.
- Job security: There’s no need to worry about layoffs or upheaval — an ESOP keeps people in their roles with their job security intact.
- A reward for loyalty: It’s a great way to thank your team for their dedication over the years.
Business benefits
- Tax advantages: The company itself can benefit from substantial corporate-level tax deductions that help reduce costs.
- Talent magnet: An ESOP can attract top-tier employees who are looking for more than just a paycheck — they want a piece of the action.
- Increased productivity: When employees have a vested interest in the company’s success, productivity and morale often soar, securing your legacy and also increasing the value of any portion you sell over time.
Disadvantages of exiting using an ESOP
As mentioned previously, ESOPs also have their downsides. While they can often be a fantastic exit strategy, they’re not without challenges, such as:
- Complex rules and regulations: ESOPs are subject to regulations of the Employee Retirement Income Security Act (ERISA), which are overseen by the Department of Labor (DOL). These regulations are designed to help ensure the ESOP is managed appropriately and that participants are treated fairly. However, the regulations can be complex and difficult to manage, so it’s wise to work with an experienced advisor and team who can help ensure your transition remains in compliance.
- Liquidity requirements: In order to successfully execute an ESOP transition, the business must have enough capital to buy back shares from retiring employees and others who leave the ESOP after vesting. Referred to as “repurchase liability,” this liquidity must be maintained in order to keep the ESOP trust solvent.
Could you use help determining whether an ESOP exit plan makes sense for your business? Your Creative Planning Wealth Manager works closely with our in-house team of Business Services professionals to provide full support from the initial feasibility phase through closing the transaction — and can even support the new employee owners thereafter. To learn more, contact your wealth manager or schedule a call with a member of our business services team.
