Compared to a traditional company sale, an employee stock ownership plan (ESOP) may provide a more flexible and economically attractive solution for company owners or shareholders seeking liquidity. In a leveraged ESOP transaction, the ESOP (newly formed or existing) purchases the stock of one or more shareholders through newly funded company debt within a tax-advantaged structure. Funded debt can be structured to minimize taxable income (maximizing corporate tax deductions) using multiple debt tranches, customized amortization and warrants.

Compared to other transaction alternatives, the ESOP structure may be more advantageous for a number of reasons, including:

  • Compelling Tax Benefits. There are notable individual and corporate tax advantages for selling shareholders, the company and employees:
    • Depending on how the transaction is structured, selling shareholders may be able to indefinitely defer capital gains taxes on their transaction proceeds, resulting in an upfront savings equal to the capital gains tax rate and potentially higher. In every case, the transaction is structured as a sale of stock versus a sale of assets.
    • For corporate tax purposes, a company is able to deduct, within certain limits, principal payments on ESOP-related debt, as well as certain dividends paid to the ESOP. In essence, a company is utilizing pre-tax dollars to reduce its debt balance, albeit at a more accelerated pace, and to pay dividends. Interest on ESOP-related debt is also tax deductible.
    • Because the ESOP is a defined contribution plan, similar to a 401(k) retirement plan, employees’ ESOP ownership interests in the company grow on a tax-deferred basis.
  • Structuring Flexibility. Shareholders determine how much equity they wish to sell to the ESOP as well as the requisite timing—either upfront or over time depending on desired goals, debt structure limitations, and company cash flow projections. Owners often choose to sell between 30% and 100% in the initial transaction. A non-ESOP equity incentive plan may also be implemented specifically for senior management as part of the overall transaction.
  • Owner/CEO Benefits. Unlike other transaction structures, an owner/CEO may retain day-to-day control of the company if he/she chooses, irrespective of the amount of equity sold. If not already in place, a board is typically formed and members are chosen at the discretion of the owner/CEO.
  • Simplified and Expeditious Transaction Process. Depending on the complexity, the ESOP process may take between three and four months to complete. Confidentiality and due diligence issues that often occur in a traditional sale process are eliminated.
  • Employee Ownership. Implementation of the ESOP allows employees to become indirect company owners at no upfront cost. Studies have shown that employee-owned companies often outperform their peers as a result of having an ownership interest.

While there are many advantages to an ESOP structure, there are a number of considerations worth noting.  The valuation ascribed to a company as part of an ESOP transaction is determined by an unaffiliated, independent third-party appraiser. This valuation will serve as the basis for how the transaction is structured and directly impact the proceeds of selling shareholders.  Additional annual company valuations must be completed at a nominal cost in order to calculate the value of ESOP holdings. In addition, a company must hire an independent trustee/fiduciary that represents the interests of ESOP participants.  A Company must also plan for its repurchase obligation, which is the Company’s future obligation to repurchase vested shares from departing employees upon retirement, death, disability or termination.

These considerations are manageable but must be evaluated within the overall context of the transaction.  For many companies, the advantages of an ESOP structure outweigh the considerations, which is why this structure is gaining in popularity among owners and shareholders seeking liquidity, especially in a rising tax rate environment.

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Opus Advisory Partners advises company owners on the initial feasibility as well as the structuring, financing and implementation of an ESOP.  Our firm also analyzes and compares the various exit liquidity options available to owners, providing decision-making clarity on how to maximize value and after-tax proceeds on a risk-adjusted basis.