But selling to employees only works if certain business fundamentals are in place.
A tremendous amount of wealth will soon be transferred from the Baby Boomers to the next generation. Many of the companies that were started from scratch, purchased, gifted or inherited will need to be passed along to someone else, because we won’t live forever. There has been some delay in this process because of the Great Recession. Starting in early 2008, we began to see a significant decline in the earnings power of a large number of businesses. As a result, publicly traded and private company values declined, on businesses of all sizes and in almost all industries. Some companies bounced back faster, but overall the growth in business values has been inconsistent.
As economic conditions have improved, business owners ask themselves what they should do about cashing out of their life’s work. Among the most likely options: Sell the business to employees, gift or sell the business to family members, or hire an investment banker or business broker and sell the business to a third party.
Gifting or selling to family members may be a good decision. However, a sizeable amount of wealth may have been accumulated as part of the business, and it may be difficult to realize this value by gifting it to your children. Tax issues are a concern, as are questions of whether a succeeding generation has produced the right leader.
Third-party sales present challenges with finding the right buyer and the time needed to do that, and the impact on corporate culture can’t be discounted.
But for this discussion, let’s focus on a sale to employees, which can have significant advantages. Congress has recognized that a sale to your employees should be encouraged and has provided tremendous tax incentives to make that happen. There is a fundamental reason for this: We all know that the employees are critical to the success of almost any business. They, along with management and the board of directors, are responsible for generating the earning power of the business. The employees are limited in their financial reward because they are not shareholders. A sale of the business to an employee stock ownership plan, or ESOP, will change this situation.
An ESOP is a trust funded by company contributions that are tax deductible. The employees generally do not put any of their own money at risk in the initial transaction. These transactions are typically funded by bank debt or seller financing. You can think of these transactions as giving the business owner the ability to redeem all of his stock at fair market value, the price for which the business would change hands in a third-party sale. The great thing about an ESOP transaction is that the principal payments are tax deductible, so the cash flow to service the debt is significantly higher than in the case of a traditional leveraged buyout. Another tax benefit the seller can enjoy is deferral of capital gains on the sale of the stock if a certain tax election is made.
The benefits do not end there. If, in an ESOP transaction, the company elects to be taxed as a Subchapter S corporation, no income tax will be owed on the earnings allocated to the shares held by the ESOP. So a 100 percent S-corporation ESOP will pay no corporate tax and the tax savings can be used to service debt and pay retirement benefits.
The way a tax is ultimately paid is through the future withdrawal of funds from each participant’s retirement account. Keep in mind: The company will continue to be run by management with oversight by the board of directors. The employees have no direct say in how the company is managed, unless they are part of the management team. So the way in which a business is managed does not change just because the ESOP owns the stock. However, the board continues to have corporate responsibilities and the trustee of the ESOP must look out for the interests of the plan participants.
So if a sale to an ESOP is such a great thing, why doesn’t everyone do it? It requires that management be in place (at some point) to run the business on a profitable basis. This may not always be the case. The business generally must have sales of several million dollars and at least 15 or so employees to justify the costs of implementing an ESOP plan. An ESOP will pay what a third party would pay for the stock, but it will not pay more than fair market value. The transaction must be able to cash flow, or the ESOP will not make the purchase. The seller must have some patience because numerous parties are involved (business appraiser, attorney, third-party administrator, etc.). An ESOP is a retirement plan, so it must be treated with fairness and with fiduciary oversight.
The good news? ESOPs have developed a great track record. Research shows that, overall, ESOP companies grow faster, offer higher benefit levels to employees, had fewer layoffs during the Great Recession and fewer loan defaults. We have some outstanding ESOP companies in Kansas City. They have received a lot of media coverage and have generally been companies that make the list of the best places to work.
Moreover, an ESOP sale can take place in stages, with smaller amounts sold initially. The owners can take their time in getting out and can move the transaction along at a measured pace.
Regardless of your selling strategy, it’s critical that a preliminary valuation of the business be performed to determine its true worth. Once you know the value of the company (valuation is not an exact science), you can make an informed decision about the next step in transitioning your business to meet the needs of the owners.