You’ve heard about Employee Stock Ownership Plans (ESOPs) and know they offer a succession strategy for your company that provides you with liquidity and gives your employees a foundation for the future. What’s the next step for exploring this option?
An ESOP feasibility study is the first, formal step a business owner and company leadership should take when considering implementing a sale to an ESOP. While not unique to the ESOP world, the term feasibility study is used quite consistently among ESOP advisors. However, they’re often describing different things, as each advisor offers a different version of the feasibility study, which can cause confusion for the consumers of ESOP advisory services.
We believe an ESOP feasibility study should provide a full, detailed analysis that helps you decide whether an ESOP is right for you, as well as the “road map” for the specific ESOP structure you should pursue.
Specifically, you should know the following when the feasibility study is complete:
- Which structure option will best meet the seller’s goals
- How much of the stock the seller wants to sell to the ESOP
- The value of the stock the ESOP will purchase
- How much liquidity the seller will receive in the sale
- If seller financing will be required, the financial terms of a seller note
- Whether the seller’s proceeds will be taxed
- How the company will be incorporated going forward (C corporation or S corporation)
- What the company’s cash flow will look like post-ESOP (inclusive of debt service and tax benefits)
- What the expected employee benefit level from the ESOP sale will provide
- How much time and money a company should expect to invest to close an ESOP transaction
Before you obtain a formal feasibility study for your business, you should educate yourself about ESOPs. Knowing the basics can help you rule out an ESOP right away if it is not appropriate for your company or goals. For instance, an ESOP is intended to be a broad-based retirement plan including all or nearly all employees. Therefore, it is not a good fit for business owners who want to include only their senior management team in the ownership group. ESOPs are also not a good fit for companies with too few employees, as these companies will have a harder time remaining compliant with regulations. These other questions can be addressed quickly and easily, without incurring any fees. Once you have been through this education process, you can obtain a feasibility study to help you decide whether an ESOP works for you.
Feasibility Study Team and ESOP Process
If your company does move forward with an ESOP, the feasibility study you commission will provide valuable information. Ultimately, the ESOP transaction will involve several professionals, including advisors to represent the employee participants (the buyers; see our article on ESOP Trustees), who need not be involved in the feasibility study. If the study is performed only by advisors representing your company, this will keep the study’s focus on the company and shareholder needs, minimize fees, and streamline the transaction process as a whole.
As we have discussed elsewhere, the ESOP transaction process is more predictable than most other M&A processes, thanks to the Department of Labor mandate that ESOP trustees follow the Fair Market Value standard when deciding how much to pay for stock in an ESOP transaction. While a Fair Market Value calculation will vary between valuation professionals, you should expect that variation to fall within a reasonable range. The feasibility study will include those numbers and thus give you great insight into how an ESOP trustee will value your specific business.
This value range is combined with extensive knowledge of the capital markets and how various lenders view ESOPs, enabling us to provide you with a very good estimate regarding the value and liquidity you can expect from an ESOP transaction. This estimate is a key deliverable in the feasibility study.
Many of the outputs in an ESOP feasibility study are derived from the results of a detailed financial model and seller preferences. For instance, the decision to be a C corporation or an S corporation will depend on several factors, including shareholder basis, state of incorporation, and company-specific tax rates. However, it generally comes down to how much the seller can save by deferring capital gains taxes versus how much income tax the corporation can shield with the ESOP tax advantages. This is an apples-to-oranges comparison, but the ESOP feasibility study outlines the tax savings in either scenario. Looking at multiple structures is imperative for understanding what will work best to achieve your goals and what is best for the company going forward under ESOP ownership.
Similarly, how much of the company to sell to the ESOP usually depends on the seller’s personal preference, and the ESOP feasibility study will provide the information you need to make that decision. Often, business owners sell 30% of the company — the minimum to qualify for the powerful personal capital gains tax deferral — or they sell 100% because that results in a tax-exempt ESOP-owned company moving forward. The ESOP feasibility study will also evaluate potential estate and gift opportunities, management incentive plans, and many other data-driven decisions. Making these decisions as part of the feasibility study will save the business owner and the company time and expense down the road.
The ESOP feasibility study is a playbook the advisors craft with the seller and the company, with the goals of the seller and the long-term success of the company in mind. It ensures all parties are working together and gives you a fully vetted, actionable plan with which to close the ESOP transaction efficiently.
David Jasmund, Shareholder