Partial ESOP: A Liquidity Strategy for Business Owners Who Want to Retain Control

A Flexible Liquidity Strategy for Shareholders, Companies, and Employees

A partial ESOP can help business owners evaluate personal liquidity, company continuity, employee benefits, and ownership transition without requiring a full sale.

As privately held businesses mature and grow in value, the desire for, and prudence of, personal liquidity and diversification grows in importance to business owners. When much of one's personal net worth is tied to a highly successful business, the owner is often faced with the question "How can I personally diversify yet continue to run my company successfully and provide meaningful benefits to my employees?"

The use of an Employee Stock Ownership Plan, or "ESOP," provides business owners a distinct advantage regarding personal liquidity and business transition. The ESOP allows the business owner to cash out a portion of her/his equity and retain their role in the company while providing excellent tax benefits to both the shareholder and the company. Furthermore, the financial benefits an ESOP provides to the company and its employees are significant.

business owners are using ESOPs to convert some of their illiquid privately held company stock into cash and other liquid investments. A partial ESOP strategy is particularly relevant for business owners who want to continue operating and owning a portion of their business while diversifying assets, a prudent part of personal wealth management.

ESOPs are attractive for their tax savings to the owner and company, flexible deal structures, and the speed with which a transaction can be completed. Capital markets continue to be active participants in ESOP deals and provide significant liquidity at closing, so now is a great time to evaluate this liquidity strategy.

Why a Partial ESOP Can Be a Flexible Liquidity Strategy

A partial ESOP can be considered when a business owner wants liquidity, employee ownership benefits, and transaction flexibility without selling the entire company.

Determining when and how to exit your business is one of the most important and personal decisions you will make throughout your career. An Employee Stock Ownership Plan (ESOP) is a particularly attractive vehicle, given the flexibility it provides. An ESOP offers a tailored approach to selling your business.

Selling to an ESOP offers meaningful liquidity while providing significant benefits to the company's employees and delivering a powerful corporate finance tool that provides tremendous tax savings to both the owners and the company.

Unlocking the power of an ESOP is not an all-or-nothing decision. An ESOP is content to own any amount of stock ranging from 1% to 100%. While the tax benefits are maximized as the company becomes 100% ESOP-owned, there are many instances when a full sale is not the best strategy because of either timing or circumstances. ESOP planning resources

This article will explore some of the instances where a partial ESOP could result in a win-win for all stakeholders.

Desire for Wealth Diversification

Owners whose personal wealth is concentrated in a private company may consider a partial ESOP as one way to diversify while retaining majority ownership.

Many times, as a business grows and matures, the percentage of wealth that a business owner has in the company grows as a percentage of overall wealth. Diversification of wealth through selling a portion of the business is a prudent option, and an ESOP can be a powerful tool to achieve this goal. As you evaluate liquidity strategies, value and control become a driving force in the transaction.

ESOPs are designed to pay fair market value (FMV) for the stock they purchase but do not have a mandate when it comes to ownership percentage. Therefore, you can sell a smaller percentage of the company to the ESOP for cash and realize meaningful diversification while maintaining a majority ownership position in the Company. Selling a minority stake in a company is not a transaction that many third-party buyers are interested in, but an ESOP is a good fit in this situation.

Value is often at the forefront of the business owner's mind when she/he begins to evaluate liquidity strategies. The value of a company whose shares are sold to an ESOP is determined by a valuation approach that centers on Fair Market Value ("FMV").

When the FMV of the business is established, the business owner can determine how much liquidity she/he desires to diversify personal holdings. The ability to control the percentage of the business being sold is just one of the reasons ESOPs are so appealing to business owners.

ESOPs Maintain the Legacy of the Business

A partial ESOP can help owners preserve business legacy because the ESOP can be a financial buyer and passive investor rather than a full-control buyer.

It is only natural that business owners want to retain the legacy of a business they have spent years building. Most other business divestiture options would require a majority or full sale of the business, but an ESOP does not. The ESOP is a financial buyer and passive investor that is indifferent as to the percentage of the company it owns, including a minority position. The actual shares are held within an ESOP trust that is governed by a fiduciary.

The employees do not own the shares directly, they are the beneficiary of the trust and all assets owned within the trust. This indirect ownership model does not provide a mechanism for day-to-day control by the ESOP participants. From a governance perspective, the company often operates the same post-transaction as it did pre-transaction; this is particularly true in the case of a partial sale to an ESOP.

This partial sale allows the current owner(s) to retain the majority of the equity value while still providing a meaningful retirement benefit to the ESOP participants.

Achieve Multiple Shareholder Objectives

A partial ESOP may help address different shareholder goals when some owners want liquidity and others want to remain involved in the business.

Differences in opinion are bound to happen when individuals are in a group, and the same is true for multiple shareholders of a company. Often, reaching a unanimous decision about when to sell and for how much is difficult at best; at worst, it is a distraction that harms the operating business performance. Implementing an ESOP can help alleviate the pressure of the group, as an ESOP can be tailored to each shareholder's desire.

For instance, one shareholder may decide that it's time to retire, while another may be looking to stay on for many years. The ESOP can be tailored to meet both of these objectives, and provide liquidity for the exiting shareholders while not threatening the position of the remaining owners.

Additional reading: ESOPs - Keeping Family Businesses in the "Family"

Achieve Estate-Planning Objectives

A partial ESOP may be relevant when family owners need to evaluate estate-planning objectives, liquidity, and continued ownership for family members involved in the business.

Many times, owners of privately held businesses have much of their net worth tied to the business, which can create issues when estate planning and especially in dividing personal assets to their children. In these types of instances, an ESOP can be a powerful tool in estate planning for leaving personal assets to children whether they work in the business or not.

We have seen a wide array of family involvement that runs the gamut from children being groomed to be the next "heir" of the family business, all the way to the children wanting nothing to do with the company. In either case, an ESOP will help those both "in" and "out" of the business. A partial ESOP can be installed to create liquidity for those children outside the business and at the same time, continue ownership for those who wish to remain to operate the business. Read more on this topic here.

Tax Efficiency

A partial ESOP may involve tax considerations for both the company and selling shareholders, but all tax-related claims require legal and tax review before publication.

Congress enacted tax incentives for ESOPs in 1974 that provide advantages for not only the company but the shareholders as well. While the tax benefits are maximized when the company becomes 100% ESOP-owned, a partial ESOP can still participate in the tax benefits for the portion that is sold. For the company, employer contributions to the ESOP are tax-deductible up to a limit of 25% of covered payroll.

In a leveraged ESOP, companies making these deductible contributions are effectively making both principal and interest debt payments tax-deductible, as opposed to non-ESOP companies, where only interest is deductible. If you are selling stock of a C corporation (C-corp) or a company that converts to a C-corp, the IRS allows for the deferral of capital gains taxation on the stock that is sold provided that at least 30% of the stock is owned by the ESOP post-transaction.

For sellers of S-corp stock, all proceeds over basis are taxed at capital gains, whereas in a sale to a third party the proceeds are likely taxed at a blend of capital gains and ordinary income tax rates. Regardless of the tax election or amount sold to the ESOP, the tax incentives for both you and the company create a compelling reason to consider an ESOP.

ESOP Financing

Financing is an important part of a partial ESOP transaction because transaction structure, cash flow, leverage, and tax treatment can affect liquidity and debt repayment.

The capital markets remain robust and available with favorable terms for ESOP transactions, especially, in a partial/minority sale to an ESOP. An S corporation ESOP pays no federal tax on its percentage of ownership income attributable to the ESOP trust which allows for increased cash flow to repay bank debt. Banks and capital providers welcome the minority ESOP transaction, which allows them to get comfortable with the business operations without having too much leverage on the company, allowing the company adequate cash flow to service its debts and fund its operations.

Read more about ESOP Tax Advantages.

How a Partial ESOP Can Provide Liquidity While Retaining Ownership: A Case Study

The case study illustrates how a business owner might evaluate a partial ESOP against other liquidity strategies while retaining ownership and considering employee benefits.

Consider John, a 50-year-old business owner of an electrical distribution company. John started the business 15 years ago and has achieved fantastic growth, but personal goals have him contemplating exiting the business entirely at age 60 (10 years from now). However, the uncertainty around the timing of his personal plans and whether the M&A market will be strong at that time have him evaluating a partial liquidity strategy today.

John and his advisors examine different liquidity strategies: a leveraged recap, a sale to an outside equity investor, and a partial sale to an ESOP. To determine whether this strategy aligns with his financial and business objectives, John undergoes an ESOP feasibility study to analyze valuation, tax implications, and financing options.

After careful consideration, he decides to pursue a partial sale to an ESOP for several reasons: better financing alternatives, ability to retain control, the benefit to his employees, and personal and corporate tax savings.

ESOP Financing: How to Fund a Partial ESOP Sale

A partial ESOP sale may be funded with senior debt, subordinated debt, and transaction structuring that should be reviewed for company-specific feasibility.

The debt market is a large supporter of ESOPs, providing approximately two to three times the cash flow on partial ESOP transactions. Exploring various ESOP financing options is crucial to structuring a transaction that aligns with business goals and liquidity needs. John receives offers in the $20 million range from senior lenders as well as offers for another $5-$7 million of subordinated debt.

John and his investment banker decide to limit the total outside debt to $20 million, which equates to approximately 30% of the value of the business. After the transaction is completed, John will own 70% of the business and the employees will own 30% through the ESOP trust.

With this strategy, not only has John been able to take cash off the table, but he has also deferred the capital gains taxes on the sale. Because he converted his company to a C corporation, John has the ability to sell his shares to the ESOP and defer all the capital gains taxes. This significant tax advantage, along with other potential benefits, is covered in-depth in our ESOP tax overview.

Another nice feature of ESOPs is that any corporate structure allows repayment of debt with pretax dollars, which is a huge advantage in doing a recapitalization through an ESOP. Understanding the nuances of structuring an optimal ESOP ensures that business owners maximize these financial benefits.

ESOP Tax Benefits: How a Partial ESOP Maximizes After-Tax Proceeds

A partial ESOP may affect after-tax proceeds, transaction timing, succession planning, and employee ownership, but these claims require review before publication.

Creating an ESOP and completing a transaction in a shorter time frame than what a sale to an outside buyer would require allows a current business owner to sell some stock in the near term while continuing to own the majority of the business for an indefinite amount of time. Understanding the ESOP transaction process is key to ensuring a smooth transition and maximizing financial outcomes.

While John has been able to solve his desire for liquidity, he has also realized several other benefits:

• Employees have a greater stake in the business; they are now thinking like owners.
• A succession plan is in place.
• The management team's readiness is attractive to future buyers of the business as well as to lenders.

In today's marketplace, the flexibility and benefits of a partial sale to an ESOP are incomparable, and it should be considered as a liquidity strategy.

Drive Employee Performance and Provide Long-Term Benefit

An ESOP can be positioned as a long-term employee benefit and a potential tool for employee-owner alignment, retention, motivation, and performance.

Aside from being an attractive structure for a selling shareholder, an ESOP is ultimately a long-term retirement benefit for employees who have been integral in the growth and success of the company. The installation of an ESOP, regardless of size, signals to employees that the company appreciates them for their contributions and believes they should benefit financially from those contributions.

Owners and management teams often focus on building a strong company culture, and an ESOP is a tool in shaping and achieving that goal. Furthermore, research has shown that the alignment of employee incentives through an ESOP enhances employee retention and motivation that, in turn, can lead to an improvement in performance.

In an already flexible structure, a partial ESOP offers ultimate flexibility to accomplish individual shareholder goals while not disrupting the underlying business. Additionally, implementing an ESOP of any size allows all stakeholders to benefit and effectively aligns incentives for the business and employees. Even if the shareholder(s) is not currently ready to sell the whole company, a partial ESOP is a worthy consideration.

ESOP Culture Enhances Employee Benefits

When the ESOP participants assume the employee-owner mentality, they tend to think more about the business's day-to-day operations and how their choices affect the business as a whole, resulting in a positive culture and overall improvements for themselves, the company, and any other shareholders. Further, the employees are likely to receive above average returns on the stock.

The benefits of ESOPs are not just theoretical and qualitative. According to the National Center for Employee Ownership (NCEO) 1, ESOP companies are 25% more likely to remain in business and over a 10-year period also experience 25% higher job growth than comparable non-ESOP-owned companies.

The NCEO found that employee-owners were four times less likely to be laid off during the most recent recession, affording employee-owners greater job stability and benefiting companies through strong employee retention. Ultimately, the enhanced productivity results in higher sales (approximately 2.3% per year). For an employee owner, this translates into an average retirement account that is 2.5 times larger than comparable non-ESOP-owned employee retirement accounts.

Further highlighting the ESOP's tremendous benefit, the NCEO created the Employee Ownership (EO) Index in 2017. Over a two-year period (2017-2019), the EO Index outperformed both the S&P 500 and the Russell 3000 in each of those years. Over that two-year period, the return of the EO Index was 48.1%, compared with 24.1% and 24.2% for the S&P 500 and Russell 3000, respectively. 2

ESOP Benefits for the Shareholder, Company, and Employees

The example above considers a 30% sale to an ESOP and highlights some of the benefits provided to all involved.

As a business owner, it is vital to contemplate the transition from equity to cash. Taking steps to entertain all options will provide you with a path toward achieving your goals. An ESOP will give you the ability to achieve all your objectives while providing powerful tax advantages and employee benefits to retain and attract talent.

Selling a minority position in your company to an ESOP allows you to retain the majority of equity that provides increased stock value as your business continues to grow and prosper. For more information on how an ESOP will benefit you, please contact us or visit our website and PCE's ESOP Library of Information.

Frequently Asked Questions About Partial ESOPs

What is a partial ESOP?

A partial ESOP is an Employee Stock Ownership Plan transaction in which the ESOP owns less than 100% of the company. The article explains that an ESOP can own a minority or majority position, depending on the shareholder goals and transaction structure.

Why would a business owner consider a partial ESOP?

A business owner may consider a partial ESOP to create personal liquidity, diversify wealth, retain a role in the company, preserve business continuity, and provide employees with a long-term ownership-related benefit.

Can a partial ESOP help a business owner retain control?

The article explains that a partial sale to an ESOP may allow current owners to retain the majority of the equity value while still providing a meaningful benefit to ESOP participants. Governance and control statements should be reviewed before publication.

How can a partial ESOP support family business succession?

The article explains that a partial ESOP may help address family and estate-planning objectives by creating liquidity while allowing some family members or owners to remain involved in operating the business.

What tax issues should be reviewed in a partial ESOP strategy?

The article discusses ESOP tax incentives, covered payroll deductions, leveraged ESOPs, C corporation stock, S corporation stock, and potential capital gains deferral. These claims require legal and tax review before publication.

Will Stewart

Eric Zaleski is a Managing Director at PCE and a key member of the firm’s ESOP Advisory Group. Based in the Chicago area, he brings 25 years of experience helping middle-market business owners implement and finance complex ESOP transactions.

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