Last week’s Wall Street Journal ran an interesting article in the U.S. print edition, titled “Founders Cash Out, but Do Workers Gain?” (April 18, 2013)  The article discusses Employee Stock Ownership Plans, also known as ESOPs, and selected aspects of selling a privately held company to employees.

The article raises some points worthy of consideration if you are an owner of a private company contemplating doing this, or contemplating an exit in any manner.  Incidentally, there are seven channels through which owners may transfer equity; selling to employees is merely one of them.  Furthermore, an ESOP is only one method of selling to employees.

If you are contemplating an exit, you owe it to yourself to consider the array of options, not just one.  Part of our role as investment bankers is to help educate owners on the options, guide them toward the most suitable one(s), and then manage the team of expert advisors to execute the transaction.

Time Sensitivity

It’s important to realize that advance planning can be critical.  Some ownership divestment options take a significant amount of time to prepare and/or “season” for tax qualification.  In particular, implementing an optimally structured ESOP may take a few years to achieve the most favorable tax treatment.

If you are ready to start thinking about exit planning at all, the sooner that process begins, the more and better your options will be.  If ESOP is an appropriate equity transfer method for your needs, it is a tool that you should start to implement today by accruing money for a later exit.

In general, if you are contemplating succession/exit planning, I suggest that we confer to explore this and other methods that deliver liquidity and diversification, some of which require more than one fiscal year. 

Why an ESOP?

The principle reasons owners may favor an ESOP exit option are:

1. Reward valued employees, “golden handcuff” them to the company, and/or “protect” them from the uncertainty of other new owners’ intentions
2. Take advantage of generous tax incentives to divest to employees, rather than outside interests
3. Private company owners can sell all or part of their equity to an ESOP, often completely avoiding capital gains tax on the transaction
4. Owners may phase their exit over time, maintaining control and preserving the company’s culture (may be particularly important when family members are taking over)
5. Owners can sell some stock in the company, pay no tax on the proceeds, and maintain control
6. Employees need not make a cash outlay.  Proceeds to buy owners’ shares can be borrowed from a bank; alternately, the company may use its cash to buy existing shares or issue new shares.

While the use of the ESOP exit option has grown steadily since its introduction in the 1970’s, it still represents a relatively small subset of American companies – an estimated approximately 11,000 businesses employing 10 million people.  Virtually all participating companies have fewer than 500 employees.  Only about 15% of them are publicly traded.

Why Not an ESOP?

The principle reason private company owners may not favor an ESOP exit option is that it is typically not the most lucrative choice for the selling shareholders.  Since ESOP ownership interests are valued on a “Fair Market Value” basis, by Federal statute, owners whose companies would have more value to outside purchasers/investors lose the opportunity to sell for a typically higher “Financial Market Value” or “Synergy Market Value.”  In many cases, the difference is substantial.  However, there are generous tax benefits that shelter capital gains and dividends tied to an ESOP, which may narrow, or possibly close, the gap.

They are also complex to implement and administer, and tightly regulated.  Furthermore, not all companies are good candidates.

ESOP Legislation Pending

The catalyst for this Wall Street Journal article is that last week a bipartisan group of lawmakers introduced a bill to encourage employee-ownership plans.  Doing so is not without controversy.  There are well-meaning and well-informed people advocating for either side of this issue: encouraging employee ownership is good tax policy because it encourages desirable behavior on the part of both company owners and employees; it is bad tax policy because it will encourage employees to take on more risk by keeping too much of their personal assets in one place, and it wastes tax revenue.  According to the critics, those assets may be what employees count on for retirement, and if the company fails, the employees are left without adequate savings.

Both arguments have merit. There is a lot of data to suggest that employee-owned companies were more resilient to the recession, in addition to many other favorable metrics. There is much to be said for encouraging employees to think of where they work as “our company,” and loyalty and productivity tend to be higher.

On the other hand, one need only recall the names WorldCom, Enron, Lehman Brothers and Arthur Anderson for an example of employees who lost most, if not substantially all, their assets planned for funding their retirement.  While I am not aware of these companies having ESOPs in place, they did have many employees with a large proportion of their personal assets tied to the company’s stock (in the case of Enron, by management edict).

We all know the admonition to “not put all your eggs in one basket,” but a well structured ESOP can avoid that problem.  Often, the ESOP assets an employee accrues over his or her employment tenure are incremental to what they have acquired through a 401K plan, so they are “icing on the cake.”

Conclusion

As with most things in life, there are pro’s and con’s to employing an ESOP to divest ownership.  There is no one-size-fits-all answer, and the ESOP structure is great for some situations but not others.  Each situation must be evaluated individually.

Please contact me if you are contemplating divesting ownership interest in your company, as you owe it to yourself to consider the array of options.  We will help you determine the optimal path for your needs.

Disclaimer: This article provides general information, and is not intended to constitute, and should not be construed as, legal, tax, accounting or business advice, nor does it constitute an offer to sell or to purchase securities. Rather, it is summary compilation of timely issues confronting your industry and as such does not purport to be a full recitation of the matters presented.  Prior to acting upon any information set forth in this article or related to this article, you should consult independent counsel and/or more detail contained in the Source Information. The article reflects the opinion of the writer, and does not necessarily reflect the opinions of Mid-Market Securities, LLC, or its affiliates.  IRS Circular 230 Disclosure: In order to comply with requirements imposed by the Internal Revenue Service, we inform you that any U.S. tax discussion contained in this communication is not intended to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein.