When an owner of a privately held company is planning to retire, there are many different ownership transition options to choose from. Examples include a management buyout, transfers to the next generation, a sale to a third-party buyer, an IPO, or even liquidation. Each of these options has pros and cons, which should be evaluated based on each business owner’s unique situation.
One option that owners are typically less familiar with is an employee stock option plan (ESOP). Using an ESOP as an exit strategy can be an effective way to meet many transition goals and provide for the company’s long-term success. Here are five key ways an ESOP can help accomplish these goals.
1. Tax efficiency
The tax benefits of an ESOP are unlike any other types of transition plans and can make the ESOP option a very attractive exit strategy. ESOP transactions contain tax benefits for both the owner and the business.
An owner can defer gain recognition on the sale of stock to an ESOP if certain conditions are met. The business must be organized as a C corporation and the ESOP must own at least 30% of the stock after the transaction. The proceeds of the sale must be reinvested in “qualified replacement property” within a certain timeframe. While this benefit is only available to owners of C corporation stock, some companies will consider restructuring prior to the ESOP transaction.
In addition, most if not all mature ESOPs are organized as S corporations. ESOP companies that are organized as an S corporation are essentially income tax free for the portion of the company that is ESOP owned. This gives ESOP companies a significant advantage over their peers in freeing up cash flow for debt service, reinvestments, compensating key employees and growth of the business.
2. Maintain autonomy
Benefits of an ESOP go beyond just providing a tax-efficient liquidity event for the owners. Owners of privately held or family-owned business are often looking for much more than a large payday when they exit their companies. They want to know their employees and their customers will be taken care of, and the legacy they worked so hard to build will live on. When selling to a third-party buyer, owners often can’t be sure what will happen once they walk out the door. An ESOP can help reduce that uncertainty.
3. Reduce transaction stress
Some business owners agonize over the thought of selling their business and putting it on the market. The process can not only be stressful for the owner, but it can also be a distraction to the entire company. ESOPs, on the other hand, are often referred to as a “friendly buyer.” Unlike going out to market and having to negotiate with a third-party buyer, valuation in an ESOP transaction involves a third-party valuation firm that helps determine the overall fairness of the proposed transaction. If the value is acceptable to the owner, then the lawyers prepare all required documentation and the transaction proceeds to closing. The process can be better controlled and is much less disruptive to the company.
4. Transition at your pace
Many owners have difficulty with the concept of handing over the keys to the company in one shot and prefer the opportunity to gradually transition ownership to employees. An ESOP can provide a succession strategy that allows an owner to move tranches of equity to the ESOP over time while they transition their role from CEO to board member, and eventually to full retirement.
Finally, in some situations, family-owned businesses are passed down from generation to generation, but eventually reach a point when the next generation is not willing or able to take over the reins. An ESOP not only maintains the legacy of the departing owner and the family, but it also rewards the employees who helped create that legacy.
When starting to plan for an ownership transition, it is wise to consider the pros and cons of each option and how they impact both the business and the exiting shareholder. An ESOP can provide unique advantages that may not be available through other exit channels, and in some cases the intangible factors associated with ESOPs can outweigh the benefits of those other exit paths.
Kreischer Miller is a leading independent accounting, tax and advisory firm serving the Greater Philadelphia and Lehigh Valley areas since 1975. Our firm was built to respond to the unique needs of private companies, helping them smoothly transition through growth phases, business cycles and ownership changes.
Brian J. Sharkey, CPA, CVA, CEPA, is the director-in-charge of Kreischer Miller’s business advisory practice. Katrina R. Samarin is a director in Kreischer Miller’s tax strategies practice and an ESOP specialist.