An employee stock ownership plan (ESOP) can be a very viable transfer strategy for a private company owner — and we have seen a significant increase in ESOP transactions in recent years. However, ESOPs still represent a relatively small number of the total transactions in the private market.
We believe the reason many owners and their advisors don’t address it is because they don’t fully understand the advantages of utilizing an ESOP.
Here is an overview of those overview of those in hopes that private company owners will consider an ESOP strategy when they think about their transfer options:
ESOP Benefit #1: Ability to “test drive” an ESOP as your transfer strategy
Owners selling to an ESOP do not have to sell 100% of their stock; they can sell a minority stake in the company. This allows an owner to “test drive” the strategy to make sure it works for them before they sell all of their stock.
Some private company owners prefer this approach because it allows themselves and their employees to learn how the ESOP works and adapt the company to being ESOP-owned without making a full commitment to the stock. In this regard, it is one of the only business transfer strategies that allows this gradual approach to succession, making it appealing to many companies.
ESOP Benefit #2: Ability to generate liquidity while maintaining control
As noted above, an owner’s ability to sell a minority stake to an ESOP allows them to get some liquidity but still maintain control of the company. For many private company owners, getting some liquidity provides them more flexibility in their choices and gives them more time to fully develop their exit plan.
This partial liquidity event can be a real advantage to an owner who wants to solidify their retirement without having to commit to selling their company to a third party.
ESOP Benefit #3: Private company owners can maintain their role in the business and leadership succession is gradual
With other transition options, especially a sale to a third party, the transfer of ownership in the company also means a transfer of leadership. However, many owners are not ready to stop working and have an interest in continuing in their current role or perhaps considering a gradual transition of their role.
In an ESOP transaction, the existing management stays in place and there is no forced change due to the transaction. Many owners prefer this option since they built their company on their own terms and thus prefer to exit on their own terms when they are ready.
Additionally, because ESOP companies have the advantage of more time to gradually execute their succession plan for the company’s leadership and management team, an ESOP structure provides the advantage of not forcing change too quickly and allowing succession to happen gradually.
ESOP Benefit #4: S Corp shareholders can continue ownership after the sale
If the company is an S corporation at the time of the ESOP transaction, shareholders who sell their stock to the ESOP and continue to work at the company can be allocated ownership shares within the ESOP along with the rest of the employees.
The exiting private company ESOP owner can gain the financial benefits of selling their shares to the ESOP and continue to build their retirement assets with the shares allocated to them within the ESOP plan.
ESOP Benefit #5: Rewarding and incentivizing employees
Many of our ESOP clients have a significant interest in taking care of their loyal employees who helped make the company successful over time. An ESOP offers a way to reward employees by providing them with a long-term ownership incentive plan for their retirement as well as more job stability.
It is very important to note that the employee retirement benefits derived from an ESOP cost the employee nothing. There is no employee financial contribution required to participate in an ESOP plan. The only thing an employee must do is continue to contribute to the company’s success over the long term. This additional retirement benefit is not available at most companies and can be a substantial perk for employees of an ESOP company.
ESOP Benefit #6: Improved recruiting and retention
As noted above, an ESOP can be a significant no-cost employee benefit that most companies cannot offer. Given the very tight labor market in some industries like manufacturing or construction and how hard it is to find and retain good people, an ESOP can be a substantial differentiator in a private company’s retention and recruiting strategy.
ESOP Benefit #7: Shared purpose leads to a stronger company culture and better employee performance
Data tells us that when employees are given ownership, it positively impacts their behavior because they now have “skin in the game.” Studies have shown that an ESOP company’s performance increases over time because its employees are more engaged and productive.
Knowing that they will all share in the benefits of the company’s increased success is a powerful motivational tool for employees and tends to create a strong culture and shared purpose in an ESOP company.
ESOP Benefit #8: Differentiation from competitors
ESOP companies often have uniquely positive cultures because of their employee ownership. These differences become visible to the market and can serve as a point of differentiation in the way the company interacts with its customers and suppliers.
Additionally, customer and supplier relationships with ESOP companies are often viewed as more stable because the business is unlikely to be sold to a third party. Over time, this can become a competitive advantage. Learn more about how you could use your ESOP as an acquisition tool here.
ESOP Benefit #9: Share value increases over time
The improved performance that results from a motivated workforce often manifests itself over time in increased ESOP share prices. Generally, ESOP valuations are more typical of a “financial buyer” than a “strategic buyer.” However, an exiting owner who sells tranches of shares to an ESOP over time has the opportunity for increased share values due to the company’s enhanced performance.
Additionally, such share value increases also are beneficial to employees participating in the ESOP plan since their retirement payouts can be positively affected by greater performance.
ESOP Benefit #10: Tax advantages
Numerous tax advantages arise from using an ESOP as a transfer strategy for both the selling owner as well as the company. The owner selling their stock has an opportunity to defer capital gains tax on the sale of their share to the ESOP. Also, if the company is an S corporation, the portion of the company that is owned by the ESOP is exempt from both federal and Pennsylvania income tax.
These are the principal tax advantages, but there are others that make an ESOP the most tax-efficient transfer strategy available to a private company owner.
ESOP Advisory & Tax Services for Private Companies with Kreischer Miller
ESOPs confer many long-term advantages to the exiting owner, the employees, the company, and the community. If you are thinking about your company’s future, an ESOP is worthy of your private company’s time and attention as a viable option.
Reach out to a member of our ESOP Specialist team for support with your small to medium-sized business retirement plan creation or management.