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Exit Planning: Is an ESOP the Right Exit Strategy for You?

It’s never too early to start thinking about the day when you will eventually exit the business you’ve built, grown and nurtured.

The most common include passing the business on to family members or selling it to outsiders (for example, private investors or a competitor) or insiders (your employees). Another option for accomplishing the sale of your business to insiders is an Employee Stock Ownership Plan, or ESOP.

How ESOPs Work
With an ESOP, your company will contribute ownership shares of the business or cash into a tax-exempt trust. The cash is used to buy stock on behalf of employees, who pay no tax on the contributions until they actually receive the stock later. In the meantime, these contributions and their earnings accumulate income tax-deferred.

According to the National Center for Employee Ownership (NCEO), there are approximately 11,300 ESOPs and stock bonus plans in the U.S. today, covering more than 13 million employees. The vast majority of ESOPs consist of privately held companies – less than three percent of ESOPs are in public companies, reports the NCEO.

There are many potential benefits of ESOPs to both you and your employees:

  • You can create a steady stream of retirement income. This is the primary goal of exit planning for most business owners. With an ESOP, you can structure the payout from the proceeds of your business’ sale to meet your income needs after the sale, including during retirement.
  • You can exit the business gradually over time. An ESOP enables you to liquidate whatever portion of business ownership that you choose, whenever you choose. This way, you can maintain a majority controlling interest and remain active in the business over a number of years, gradually phasing yourself out over time if you desire.
  • You can realize significant tax advantages. All company contributions to an ESOP are tax-deductible up to certain limits. And for owners of C corporations, proceeds from the sale of shares to an ESOP are taxed as long-term capital gains (currently 15 percent). Or, under IRC Section 1042, owners can defer capital gains if they reinvest the assets from the sale. S corporations do not qualify for Section 1042 and cannot defer gains on the sale of shares to an ESOP. However, the ESOP’s share of earnings is not subject to income tax. Instead, employee-owners pay taxes when they receive distributions [like they would with a traditional 401(k) or IRA
  • You can motivate and reward your loyal employees. Perhaps the biggest benefit of ESOPs is the impact they can have on employee morale, productivity and loyalty. This, in turn, helps the company maintain a higher value and a potentially higher selling price.

Various studies have demonstrated that employee-owners tend to work smarter and harder than non-owners and to be more loyal to the company. This may not only help the business grow faster and be more profitable, but it may also help ease the transition to the new owner-employees.

For example, a study conducted by Georgetown University determined that the revenue of ESOP companies grew an average of 15.1 percent during the recent recession, while the revenue of all private companies declined by 3.4 percent. ESOP firms also enjoyed employment growth, faster wage growth and higher average wages during the recession, while these metrics declined during this time for all private companies.

Keys to Success
The key to any successful business transition plan, including an ESOP, is to start planning early. Ideally, planning should start years before it’s time to actually begin the ESOP process by thinking about a few questions:

  • When do you think you’ll want to exit the business and/or retire?
  • What is the value of your business?
  • How much money will you need to accomplish your post-business (including retirement) goals?
  • Are the right employees in place to take over leadership of your business after you have left?

The last question is especially critical, because the ongoing success of your business after your exit will depend on the strength of successor leadership. You should try to identify next-generation leaders years in advance of the ESOP and begin training and grooming them for their future leadership roles.

It’s also important to provide incentives for these future leaders to remain with your business. “Golden handcuffs” like deferred compensation and phantom stock plans can incent key employees to stick around for the long term.

Things to Consider
Keep in mind that an ESOP isn’t the right succession tool for every business and situation. It takes a relatively long period of time to implement an ESOP, so if you need to exit your business quickly, it probably won’t be the best option. Also, if your employees aren’t entrepreneurially minded – or if you don’t have any employees who you believe would be strong future leaders – you should probably look at other succession options.

In addition, there are both upfront and ongoing administrative costs that can make it difficult for some smaller businesses to cost-justify an ESOP. These may include reporting, administrative and trustee fees; a plan audit; and business valuations in order to determine the stock price, to name a few. A minimum number of employees (e.g., 20 or so) may be required for an ESOP to make sense financially.

A significant investment of time is also required, on your part as well as your financial staff and your key managers and executives. So be sure to carefully weigh these costs and requirements against the potential benefits as you decide whether an ESOP might be the right succession tool for your company.

The details of ESOP planning can be complex, so if you do decide to move forward, make sure you surround yourself with a team of experienced consultants and professionals. This includes attorneys, bankers and accountants who specialize in helping businesses like yours plan and execute successful ESOPs.

We can provide valuable ESOP assistance for you and your business. For more details, give us a call today at 401-331-0500.