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ESOP

How Does An ESOP Work?

Let Them Eat Cake! Or, Have Your Cake and Eat it, Too?

Let’s face it, you’ve been doing this for a long time.  Running the company, that is. Maybe you started it, maybe you bought into it, or maybe you were lucky enough to inherit it.  Maybe you’ve been the person most responsible for its success. Or maybe, just maybe, you’ve been indispensable to the operation, at least in your own mind.  Or maybe its really true. Perhaps you have thought about ESOP, but how does an ESOP work?

Have you ever laid awake at night and wondered why no one cares as much about your business as you do?   Or tried to motivate some of your key people by promising them bonuses without much impact to the business?  Or thought about what life might be like if you could just take some chips off the table?

Perhaps you have thought about selling the Company, or maybe you’ve even been down that road.  Perhaps you are concerned with the process, or taxes, or your corporate culture, or what will happen to your people if you sell to a big public, or god forbid a private equity fund.  Perhaps you are most concerned about your legacy, or what will happen to the reputation that you have built over the last 30 years, or what people will say about you if you “sell-out”.

Well, what if I told you that there was a way to sell your company, possibly tax-free, and not disrupt the corporate culture one bit?  What if I told you that you could sell your company to a “friendly” buyer, one who would not steal your sensitive information if the deal went south.  A buyer who would keep everything intact, who would actually push for a generous benefits program, one who would encourage employee engagement, heck, one who would even require it.

How Does An ESOP Work?

Well, there is, and the way to do it is through an Employee Stock Ownership Plan, or “ESOP”.  In short, an ESOP is a vehicle to sell your company on a tax-advantaged (tax-free) basis to your employees.  You end up with many of the benefits of a sale to a third party (and if you structure it right, a whole lot more).  Your employees end up with a long-term benefit that will usually far exceed any other retirement savings that they could possibly accumulate on their own, and the opportunity to impact their own financial future each and every day.

Before I get into the details, let’s quickly review a partial list of the pros and cons of other ways that you can try to exit your business:

Sale to a Third Party 

Pros

  • You will generally get most of your money upfront
  • You will generally be free to do what you want in a short period of time
  • You may get a premium price depending on your niche

Cons

  • Potentially risky and protracted process (i.e. exposing your deepest darkest secrets to a buyer that may back out)
  • Payment of capital gains tax at least, and potentially higher rates if you are a C corporation, or the buyer shifts purchase price that results in ordinary income.
  • No control over what happens post-transaction
  • Usually results in disruption to corporate culture, displacement of employees, or both

Sale to a Family Member 

Pros

  • Can’t really think of any
  • OK, maybe that you preserve your home life

Cons

  • Kids will rarely take the company to the next level
  • They generally don’t have your skillset, so getting paid is risky
  • Talented executives may resent you for it, and separate from the business
  • No tax advantage unless you gift some or all to them
  • Gifting the business doesn’t get you any cash

Sale to Your Management Team 

Pros

  • They know the business and see it potential
  • Streamlined, less risky due diligence
  • Motivated to make the deal work

Cons

  • Management teams generally don’t have any money
  • No tax advantages
  • Could sour relationship if deal craters.
  • How to decide which ones and how much

Gifting Program to Your Kids

Pros

  • Tax Favorable if structured correctly
  • Keeps business in the family
  • Preserves legacy

Cons

  • No cash (liquidity)
  • Kids may not be able to run the business effectively
  • May be difficult to equalize economics to siblings
  • Other employees may separate or morale may be an issue
How Does An ESOP Work?

In many cases, one of the above-referenced strategies will be the best alternative for you to exit.  But in many other cases, these strategies leave something to be desired. In some cases, they can be disastrous.  So what then is this ESOP alternative, and how does it work.

Well again, succinctly put, an ESOP is a tax-advantaged vehicle to exit your business.  At its most base level, it is a structure, or a vehicle, or a trust, or in reality, a legal entity that is memorialized in a document.  When put into practice, and used to full advantage, an ESOP is a living, breathing retention, motivation, and wealth-building tool that can literally transform an organization.

From the seller’s or owner’s perspective, the ESOP provides maximum flexibility.  The ESOP can purchase all, or part of the equity of the owner, either now, or in the future.  As such, an ESOP can be an incredibly effective way to buy out a partner or shareholder when there different goals and objectives.  Some owners sell a minority interest to the ESOP, use it to motivate employees, and sell the rest later when the value has gone up. Other owners sell 100.0% to the ESOP in one transaction to maximize the full effect of the tax advantages.  Before we illustrate what is possible with an ESOP through a few examples, let’s review the primary advantages (and disadvantages) of using an ESOP as an exit vehicle

Advantages

#1 – Transaction can be structured as completely tax-free to the Seller.   Really, you say, how is this possible.  Well, bear with me on the details, but yes, in fact, you can sell your stock to an ESOP, and NEVER pay any tax on the gain.  Now, of course, there are a number of strings attached to this, but all perfectly legal, and vetted and approved by the IRS over the last 42 years (yes, ESOP’s have been around since 1974).  

The first requirement is that your company has to be organized as a C corporation.  (Not to worry, if you are an S corporation, you can always revoke the S election to facilitate the transaction).  Next, the ESOP has to buy at least 30.0% of the company. Lastly (and here’s where it gets a little tricky), you have to reinvest the proceeds into Qualified Replacement Property.   QRP is basically defined as stocks or bonds of U.S. based companies (i.e. no mutual funds, international, or real estate holding companies).  

If you are satisfied with a deferral of tax, you can simply reinvest the proceeds into your favorite stocks or bonds, and ride off into the sunset.  As long as you hold the stocks or bonds, you will preserve the deferral, and if your investments outlive you, you will never pay the tax.  Pretty nifty, right? But what if you don’t want to hold the stock you bought for another 30 years? Well, when you go to sell it, or “rebalance” your portfolio, you will trigger the gain and have to pay the tax.  So what’s the fix? I thought you said an ESOP was tax-free!

No, what I said is that is can be tax-free.  And if you want it to be tax-free, you must meet the requirements I outlined above to qualify.  But, instead of reinvesting into stocks or bonds that you may want to sell later, what you do is buy what’s known as a floating rate note, which is the ultimate form of Qualified Replacement Property.  Basically, it’s a 40 or 50-year bond, so it is almost guaranteed to outlive you (unless you are a 30-something, in which case, why are you selling the company?). The rate on the note “floats”, which means it usually sells at or near face value (as opposed to most bonds whose value rises or falls as interest rates change).  Since is sells at about face value, you can use it as collateral, and borrow up to 90.0% of the face amount. You’ll receive interest on the bond, but owe interest on your loan, but they are usually structured for these amounts to offset one another. Thus, you can “monetize” upwards of 90.0% of the value of your company, and NEVER PAY TAX on the sale.  Assuming the bond outlives you, your estate will get a stepped-up basis to the face amount of the note, and thus gain is eliminated.  

#2 – Company gets to deduct interest payments AND PRINCIPAL PAYMENTS on funds used to effect the purchase

The mechanism for this to be true is that most ESOPS are structured whereby the company loans money to the ESOP (either from funds on hand, or money borrowed from a bank).  These funds are then used by the ESOP to buy the stock from the selling shareholder. Alternatively, the seller “loans” funds directly to the ESOP by agreeing to sell stock to the ESOP in the form of seller notes.  The ESOP obtains cash from the company in the form of contributions that it then uses to repay the borrowed funds. Since these contributions, subject to certain payroll limitations, are tax-deductible by the corporation, any debt used to fund an ESOP purchase is effectively repaid with PRETAX DOLLARS (i.e. fully deductible).

#3 – After Company is 100.0% owned by the ESOP,  the Company becomes 100.0% tax-free. That’s right, 100.0% tax-free.  In other words, the company can use the 40.0% corporate tax it used to pay (or distribute to the shareholders in the case of an S corporation), and use it to reinvest in the company.  Alternatively, it can pay down debt faster, make bigger contributions to the ESOP, make acquisitions, or do just about anything it wants that enhances value. In other words, 100.0% ESOP owned companies have a HUGE advantage over their competitors, thanks to Uncle Sam (and when was the last time the government gave you any help, much less an advantage).

#4 – Employee motivation and behavior improves when they have a stake in the outcome.  As if the advantages referenced above weren’t enough, consider that a number of studies have been performed that show that ESOP companies outperform their non-ESOP counterparts in just about every measure.  The main reason for this relates to tying employee behavior to performance. When you show employees how they make a difference, and back it up with a real economic benefit that they can see, the results can be incredible.  The ESOP world is full of examples of rank and file employees retiring from their ESOP companies with many times the account balances that they would have had from a 401 (k) match or other retirement plans.

How Does An ESOP Work?

Disadvantages

Like the old economics adage said, “There is no such thing as a free lunch”.  So, what’s the catch? Well first and foremost, you ct’ easily sell your stock to an ESOP and simply walk away.  Why? Because the ESOP itself does not start out with any money of its own, which means that you as the seller, or potentially the company (or both) will generally have to borrow money to get a deal done.  Thus, you will generally get repaid over a period of time. While you will get a fair rate of interest (or in some cases a very substantial rate of return if the transaction is highly leveraged), you are going to have to be willing to stomach some amount of debt.

Second, all employees will participate in the ESOP according to their w-2.  Thus, an employee making $100K will get twice as many shares allocated to their account as a person making $50K.  Thus, if your goal is to get a disproportionate incentive into the hands of a few key people, a supplemental plan (like phantom stock or stock appreciation rights) will have to be implemented.

Third, you will have third party oversight in the form of the IRS and Department of Labor, as an ESOP is a qualified retirement plan under the Employee Retirement Income Security Act (ERISA).  If done correctly, this is not an overly burdensome issue, but it cannot be ignored. Similar to the rules that govern your 401 (k) plan, an ESOP will have eligibility requirements, vesting, etc., and you can’t discriminate or exclude specific people in an ESOP in favor of others.  

In closing, there are approximately 9,000 companies across the United States that have adopted ESOP’s.  Many have been in existence since ERISA was passed in 1974. If you are thinking about exiting your business, and you haven’t considered an ESOP, it might a good idea to learn more about it.  As it relates to your employees, you can Let Them Eat Cake. Or, if you are open-minded, don’t like to pay taxes, and are willing to stick around for a few years after a transaction, you really can Have Your Cake and Eat it Too through an ESOP.  Check next month’s issue for a more detailed dive on how an ESOP actually works in practice.

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