Selling a Business to the Employees: ESOPs

Two weeks ago, my post was about selling a business to the business’ employees. In that post I gave a passing mention to selling a business using an ESOP, an Employee Stock Ownership Plan. From the reaction to that mention, it appears that a lot of small business owners – as well as a lot of business brokers – are under the impression that such plans are only for large companies. They’re not. An ESOP is usually formed to allow employees the opportunity to buy stock in a closely held company, often to facilitate succession planning. ESOPs can be used by small companies, especially those whose employees are committed to the business and the owner has a few years to go before exiting. ESOPs are a great tool for planning an exit and providing the owner with a gradual transition. Employee stock ownership plans are designed to increase employee investment and employee drive for positive outcomes for the organization. After all, if an employee owns stock in the company, they will likely feel motivated for the company to succeed and for the firm’s value to increase. Further, employees who own stock in the company have an incentive to remain at the company, which could reduce employee turnover.

What Is an ESOP?

Basically, an employee stock ownership plan (ESOP) is an employee benefit plan that gives workers ownership interest in the company.

Larger companies often use ESOPs as a corporate-finance strategy to align the interests of their employees with those of their shareholders – because the employees become shareholders through an ESOP. Many publicly-traded companies offer ESOPs to their employees.

For private, closely-held companies – particularly those in the lower to mid-Middle Market – ESOPs give the owners a way to gradually shift the ownership to the employees over time. While providing the benefit of ownership to the employees, it also provides four key benefits to the owners:

1. It gives the owners the ability to plan and, to a large extent, control their exit and the transition.
2. Because, once enrolled in the Plan, the employees are owners, the company is likely to see more robust performance over time and, thus, be more valuable.
3. The owners using an ESOP for an exit strategy know their buyer(s), their capabilities and their commitment.
4. An ESOP allows the owners to spread out their tax liabilities over time.

Transition

A couple of comments from my post two weeks ago bear repeating. Unlike selling to an outsider, selling a business to its employees is usually – but not always – a gradual process that unfolds over years. A sale to an outside, unrelated third-party will generally have a specific closing date (or series of milestones) at which time(s) the seller will realize most of the value of the deal. Yes, there’s a transition period in both instances but, unless the transaction is structured as an earn out, the transition period in a sale to an outsider is usually limited to a relatively short period  – three to 12 months – during which the seller stays on to assist the buyer in getting up to speed. When selling a business to employees the transition period can extend for a couple of years as employees gradually gain more ownership of the business. This process is called “vesting” or a “vesting period”. This, of course, allows the employees to buy the business over time – reducing the immediate need for what might be an unmanageable amount of capital – and for the owner, the opportunity to spread out his or her tax liabilities. A longer transition period also allows the owners to make sure the employees that will eventually be running the company have all the training they need.

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Considerations When Setting Up an ESOP

Companies often provide employees with such ownership with no upfront costs. The company may hold the provided shares in a trust for safety and growth until the employee retires or resigns from the company. Companies typically tie distributions from the plan to vesting—the proportion of shares earned for each year of service.

Since ESOP shares are part of the employees’ compensation package, companies can use ESOPs to keep plan participants focused on company performance and value appreciation. By giving plan participants an interest in seeing the company’s value increase, these plans supposedly encourage participants to do what’s best for the business, since the participants themselves are owners of the business.

How to structure the employees’ vesting period – usually the proportion of shares earned for each year of service – and how employees can get access to their proportion of ownership are topics beyond the scope of this blog post and should be addressed with an ESOP professional.

When an employee resigns or retires, the company generally buys the resigning or retiring employee’s shares back at the current value. As a rule, employees who resign or retire cannot take the shares of stock with them, only the cash payment. Fired employees often only qualify for the amount they have vested in the plan.

But all of this assumes that the owners of the business are planning for their exit and that there are a number of years between the set up of the ESOP and the owners’ exit.

How Does this Impact Business Brokers?

By advising a client to set up an ESOP, it would seem that we would be advising that client to not use our services when it comes time to sell. Well, from that limited aspect, that may be true. But if our client acts on our advice to establish an ESOP, this also opens up a completely new revenue source for us and one that lasts multiple years. How? Private companies that have established ESOPs must have an outside valuation done every year to determine the value of the company shares. Business owners that understand the need for planning their exit usually have a timeline of  three to five years or more. From a business broker’s standpoint, working with a dozen companies with ESOPs can easily cover the broker’s annual fixed costs just from the valuation revenue. One cautionary note: ESOPs are of limited availability: Employee stock ownership plans are only available for S-corporations and C-corporations. Of course, it’s relatively easy to convert a limited liability company (LLC), Professional Practice or other business entity to a corporation but there are drawbacks to such conversion – most notably, tax ramifications. Before advising clients to make this conversion, an in-depth discussion must be had between the owners and a competent accountant or tax attorney; one that specializes in setting up ESOPs.