When to Consider a Partial ESOP

August 23 2019 | 4 Min Read Time

Will Stewart

E: wstewart@pcecompanies.com

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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.

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

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.

Achieve Multiple Shareholder Objectives

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

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 is a powerful tool in estate planning for leaving personal assets to children of the owners who work in the business. An ESOP also will benefit children who are not actively engaged in the business. 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

Congress has enacted tax incentives for ESOPs 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 generally 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.

Drive Employee Performance and Provide Long-Term Benefit

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 be a worthy consideration.

Contact us today to get more information on how an investment banker can help you get the greatest value when selling your business. Or, visit our ESOP Planning Library to find additional resources to help guide you through the ESOP planning process.