How to: Evaluate an Employee Stock Ownership Plan
Bill Haskell
As business owners consider transition and liquidity options, there are typically three choices: sell to a strategic buyer, a financial buyer or an employee-management group.
Selling to an outsider means change — the company's culture and vision are frequently altered and, due to acquisition debt, there are virtually always costsaving measures (downsizing, job losses, relocation, etc.).
When employees buy, they already embrace the current culture and vision and have no desire to downsize. However, employees generally lack the resources to finance a purchase. While some advisors advocate periodic grants of stock to employees (or debt-financed employee purchases), these alternatives cause significant tax leakage and are not optimal.
A way to facilitate a transfer to employee-managers is with an Employee Stock Ownership Plan. ESOPs are tax exempt, so a transfer can occur without tax implications. Also, employees don't have to contribute their money for their ESOP benefits. The key things to know:
- In 1998, Congress enacted legislation to motivate owners of closely held businesses to let their employees share in the company's stock performance.
- Congress used the tax code as the mechanism to create an incentive, providing that, if a sub S company redeems its shares from its owners (for cash and/or notes) and then transfers 100% of the shares to an ESOP, the company is no longer subject to federal or (in most cases) state income taxes in perpetuity.
- The tax savings are used to pay off the owners' notes and to provide additional cash flow to the company.
- An ESOP transaction can be structured so that, in addition to receiving notes, selling shareholders who continue to participate in the company's management can receive sizable “synthetic equity,” which is economically equivalent to stock but without the voting and control attributes. As a financial matter, if an individual has just under 50% “synthetic” in the tax-free ESOP setting, it is worth more than 100% in the fully taxable, non-ESOP situation.
- Shares are allocated to participant accounts over time and, when they leave the company, the participant receives cash equal to the value of the allocated shares to the extent that he or she is vested.
- The employees do not own the ESOP shares; the shares are owned by a trustee for the benefit of the employees. The board and management continue to run the company — just as before the ESOP.
- In short, the ESOP provides liquidity to the former owners, the board/management continues to run the company and the employees receive a tremendous benefit — all paid for by tax savings.
- The company is healthier for the long term as it enjoys greater cash flow as a result of being tax free.
Employee-owned companies have several advantages over competitors: enhanced recruiting and employee retention, statistically better performance than their peers and healthier cash flows that enable them to weather downward cycles in their respective industries. For companies looking to grow through acquisition, there's an immediate value for each acquisition as the profits attributed to the newly acquired company are also no longer subject to income taxes. Also, debt becomes cheaper since principal is paid with pre-tax dollars (this means that when a company borrows $1 million, it only has to make $1 million to repay debt — in the non-ESOP case, it would have to make roughly $2 million).
Since Maine is one of the most highly taxed states, an ESOP is a particularly compelling option.
Bill Haskell is a partner at Bellview Associates in Ellsworth. He can be reached at bill@bellviewassociates.com
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