It’s possible to sell a business—or a portion of it—without enduring the painful process of finding a buyer. And the sale can still be structured in a way that retains employees, keeps business owners involved (if they want), and reduces the tax burden of the transaction—all while maintaining a fair price.
Employee stock ownership plans (ESOPs) allow private company owners to sell all or a portion of their company to their employees. This strategy quickly and effectively creates a market for the business’s stock without having to wait months or years to find a buyer.
However, an ESOP isn’t necessarily the best option for every business. There are multiple other options to weigh, each with their own benefits and pitfalls.
Exit Strategy Options
Imagine this not-so-uncommon scenario: You own part or all of a company and want to cash out by selling your ownership interest. Maybe you’re nearing retirement and the investment in your company is your biggest asset.
If it’s a private company, one of the biggest challenges is typically finding a buyer because there’s generally no market for the stock. This means people aren’t knocking on your door, asking to buy you out. In this situation, individuals looking to sell their ownership interest have several options.
Following is an overview of each of those options: hiring an investment banker, undergoing a management buyout, or selling to a private equity firm or a competitor as well as an in-depth look at the benefits and challenges of selling to employees.
In an investment banker-assisted sale, the banker is hired to help sell a company and find prospective buyers. Generally, their objective is to sell the company for as much as possible, because the bulk of the bankers’ fees are percentage based and contingent on a successful sale.
While there are advantages to this strategy, working with an investment banker is a long and expensive process. It’s long, simply because it takes time to find a buyer, and expensive because success fees can represent up to 8% of the sale price. Investment bankers may also ask for a retainer fee to cover costs in the event the company doesn’t sell. These nonrefundable retainer fees can range anywhere between $50,000 to $150,000 for transactions below $100 million.
Private Equity Firms
Private equity (PE) firms are professionally run investment companies that expect a return on their investment. They’re very selective of which companies they invest in.
In the event a PE firm chooses to buy stock in a private company, they’ll expect to exercise significant influence in the business, often demanding preferential ownership relative to anyone else. Once in control, they actively position the company to become as profitable as possible so they can then sell their ownership a few years later.
To increase profit, they may slash expenses, terminate employees, and take over certain aspects of the business.
Competitors can represent an opportunity for a strategic sale, because they’re often willing to pay a premium to expand their market, gain customers, or simply eliminate one of their competitors.
In these situations, there’s often duplication of positions within each business, resulting in the acquirer often firing certain executives, management, and employees of the seller’s company. Owners can also be reluctant to talk to competitors about selling their business, because they don’t want their competitors to know they’re looking to sell. They may also not want to share their financial information with a company that may not ultimately buy their business.
When key management buys the company they work for, it’s known as a management buyout. They individually need to have the means to buy the stock, or to borrow enough to do so.
Individuals typically have limited access to capital, occasionally forcing the selling shareholder to accept a promissory note in exchange for their stock, which is then financed through future bonuses or excess compensation.
Alternatively, the company could borrow from its lender, then turn around and loan that money to the management team. In both of the last two options, the ability to repay the debt will be predicated on the profitability and success of the company itself.
In an ESOP purchase, ownership is transferred through the creation of an employee stock ownership trust (ESOT) that may ultimately purchase the company at fair market value. A financial advisor helps owners determine the appropriate amount.
Keeping with the principle of an arm’s length transaction, guidelines established during the formation of the trust forbid it from paying more than the advisor’s stated value for the company.
In a typical transaction, the company borrows money from the bank; the company then loans that money to the ESOT; and the ESOT then gives the money to the seller in exchange for the stock.
How It Works
Why Sell to an ESOP
Selling to an ESOP can potentially benefit everyone involved, including the seller, the company, and the employees. Here’s how.
- Create a buyer instead of finding one
- Receive a fair price
- Potentially don’t have to pay taxes on the sale
- Continue the company’s legacy
- Retain employees
- Deduct principal payments on the transaction from federal taxes if they’re structured as a C corporation
- Avoid paying federal taxes if structured as an S-corporation—these tax savings often fund repayment of the transaction debt
- Often outperform their competitors, because employees have a vested interest in the company’s success
- Are rewarded for long-term tenure
- Gain partial ownership of the company over time without any out-of-pocket expense
- Receive payment for their shares when they retire or leave the company
- Often receive retirement benefits that exceed those of a traditional retirement plan
While ESOPs can present many opportunities, they’re also complex and subject to federal Employee Retirement Income Security Act (ERISA) regulations, which are overseen by the Department of Labor (DOL). Given their nuance and oversight, ESOPs can be difficult to structure without the guidance of advisors who are experienced working with them, and aren’t always the best option for every business.
If the DOL audits a purchase transaction and finds the ESOT paid too much, the consequences of noncompliance can be significant, often resulting in an unwinding of the transaction and other monetary penalties.
And while employees benefit from the retirement fund aspect of an ESOP, companies must also be financially capable to buy back the shares from employees as they retire or leave the company. This necessity is known as a repurchase liability and must be planned for.
We’re Here to Help
For more information on how an ESOP could potentially benefit you and your company or assistance assessing the fair market value of your business, contact your Moss Adams professional.