An 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 markets. We believe the reason is that many owners and their advisors don’t address it because they don’t fully understand the benefits of an ESOP.
Here is an overview of those benefits in hopes that owners will give the ESOP strategy proper consideration when they consider their transfer options.
- Ability to “test drive” an ESOP as your transfer strategy – Owners selling to an ESOP do not have to sell 100 percent 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 their stock. Some 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 of the stock. In this regard, it is one of the only transfer strategies that allows this gradual approach to succession, making it appealing to many companies.
- 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 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.
- Owner can maintain their role in the business – 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. An ESOP allows an owner to accomplish that objective. 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.
- Gradual leadership succession – As noted above, an ESOP transaction has no effect on the company’s leadership and management after the transaction. The same team typically remains in place. Because of this, 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.
- Continuing to be an owner 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 employee- The exiting 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.
- Rewarding 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 substantial for employees of an ESOP company.
- 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 and how hard it is to find and retain good people, an ESOP can be a substantial differentiator in a company’s retention and recruiting strategy.
- Shared purpose leads to strong culture and better 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.
- 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.
- 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 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.
- Community support and job creation – ESOP companies tend to remain in the communities in which their business was built. This contrasts with companies that are sold to third parties which often move, resulting in lost jobs in the ESOPs keep people employed in the communities in which they live, and the company remains present in the community long after the ESOP transaction. This situation is usually a win for the company, employees, and community.
- Tax advantages - There are numerous tax advantages that 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 and, 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.
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 time and attention as a viable option.
Mario O. Vicari is a director with Kreischer Miller and a specialist for the Center for Private Company Excellence. Contact him at Email.
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