Transferring ownership of your business? Consider an ESOP
As a generation of baby boomers currently owning more than 2.3 million businesses in the United States increasingly contemplate the next stages of their lives, ownership succession planning is at the forefront of many small and midsize business owners’ minds. The JPMorgan Chase Business Leaders Outlook survey shows that one in four middle market companies (26%) are planning or considering a full or partial transfer of the business in the next two years.
An ESOP is a qualified retirement benefit plan that’s designed to provide employees with an ownership interest in the company through investments primarily in the company’s stock. It is funded by tax-deductible contributions by the employer in the form of either company stock or cash, which is then used to purchase company stock. An ESOP operates through a trust, under the direction of a trustee or another named fiduciary.
ESOPs have continued to grow in popularity over the last few years — Data from the National Center for Employee Ownership (NCEO) shows that nearly 6,700 of these plans exist nationwide and cover more than 14 million participants, with an average of 230 new ESOPs being created annually since 2010.
Despite the growth of these plans to encompass millions of workers, we’ve found from our conversations with local business owners that many are not familiar with the concept of an ESOP, much less the mechanisms behind setting one up. Advantages of an ESOP include:
• Flexibility for owners looking to exit businesses. For business owners, an ESOP allows for the sale of all or part of their company to employees, providing an exit strategy for when they are ready to retire. By permitting owners to sell between 1 and 100% of their companies, ESOPs allow for continued operational control throughout a business exit.
• Boosted employee retention and morale-building. The establishment of an ESOP creates an employee-owned structure demonstrating a commitment to sustain companies and those who work for them. Employees of companies who have installed ESOPs have noted their role in creating an ownership-based culture that builds company morale and boosts retention, as they view their jobs as more of an investment in their own futures.
• Improved output from employees who reap the rewards. Research on ESOP performance has revealed there are also many financial benefits resulting from this ownership-based culture. A study conducted by the NCEO and Rutgers University that followed 343 pairs of companies (one ESOP, one non-ESOP) over a six-year period showed that companies adopting ESOPs had increased overall sales, employment and increased sales per employee of 2.3% compared to the non-ESOP companies with which they were paired.
• Above-average wage increases and ESOP contributions surpassing those of a typical 401(k) match. The ESOP Association’s Economic Performance Survey (EPS) revealed that 75% of companies surveyed increased wages at or above the national average increase and that 55% of companies surveyed contributed to their ESOPs an amount equivalent to 11% or more of their employees’ pay.
• Significant wealth accumulation for the average employee. Research from the Institute for the Study of Employee Ownership and Profit Sharing at the Rutgers School of Management and Labor Relations has revealed that the average employee in companies with an ESOP has accumulated $134,000 in wealth from his or her stake.
• Tax benefits that increase the company’s cash flow. ESOPs offer tax advantages to the companies that implement them, which serve to increase their cash flow and ability to finance stock acquisitions. In instances where an existing owner sells more than 30% of a company via an ESOP, all the capital gains tax from the sale can be deferred, often permanently.
ESOPs can work successfully in a broad range of companies — large and small. The ideal private company candidate for an ESOP will meet most, if not all, of the following criteria:
- Strong cash flow
- History of stable sales and profits
- Generation of taxable income
- Capable management team already in place
- Annual payroll of $1 million or more
So how should business owners go about setting up an ESOP? Given the technicalities associated with selling to an ESOP and administering ESOPs, business owners who are considering the plan for their organizations should start by engaging qualified legal and financial advisers.
The process of setting one up generally starts with a feasibility study by an outside consultant, who will generally perform a valuation, develop a transaction structure and assess debt capacity. The feasibility study will focus on the company’s cash flow and its ability to handle debt service while also sustaining ongoing investment in the business. If the business owner finds the estimated transaction price and structure acceptable, the financial adviser then helps the company identify an appropriate independent trustee and, if necessary, help raise the financing for the transaction.
The trustee retained for the transaction will select a valuation firm to serve as its financial adviser and to render to it a fairness opinion on the transaction. The key component to the fairness opinion is a valuation analysis that will consider such factors including profits & cash flow, financial condition, market conditions and overall economic factors, to estimate what the company’s stock is worth. The fairness opinion and the underlying valuation work should be provided by an appraiser who’s previously not performed a valuation for the company and who can work with the ESOP trustee to provide ongoing valuation updates. In addition, the company should hire an ESOP attorney to help draft a plan and all the other transaction documentation. The trustee will also hire its own legal counsel.
On the financing side, there are multiple sources including senior bank financing, mezzanine and junior debt and seller financing. In some instances, a portion of assets in existing retirement plans can used to provide capital for the transaction. The final steps involve establishing a process to communicate to employees how the ESOP works and what it means for them as they get more involved as owners and submitting a request to the IRS for a determination letter, indicating that the ESOP is “qualified” under the Internal Revenue Code.
Experienced advisers in areas including feasibility, valuation, law and financing will be critical in helping business owners understand how to finance an ESOP, leveraging an ESOP, the potential impact of an ESOP on company earnings and compliance with legal requirements for operating as an ESOP-owned company. From there, they can help navigate regulatory and financing matters to structure plans providing strategic and financial benefits to firms and their employees.
Business owners considering ESOPs will need to think about their priorities from both business and personal perspectives. The employee-owned structure of ESOPs makes it important for business owners to leave companies in good hands upon exiting. Business owners looking to exit their companies will want to pass them on to leaders who can deliver consistent results and thus drive growth in the share price and the ESOP’s investment.
Interest in ESOPs, particularly among small and midsize companies, is expected to grow even further with the recent passage of the Main Street Employee Ownership Act, which improves access to the Small Business Administration’s loan guarantee programs and technical resources for companies looking to transition to ESOPs. It is important, then, that local business owners take the time to learn more about these plans and the potential benefits, both employee- and tax-related, they could provide to ensure a stable and successful business exit.
Keith Kepplinger is an executive director and relationship executive for JPMorgan Chase Commercial Banking based in Wilmington. Eric Zaiman is an executive director for the ESOP Advisory Group of J.P. Morgan Commercial Banking in New York City.