This blog post is adapted from my speaking points at “Preparing Your Business for Transition: The Playbook for Maximizing Your Liquidity,” a business seminar held at the Baltimore Ravens Locker Room at M&T Bank Stadium on April 23rd. For more information about the event, click here.
To say business owners frequently misunderstand the purpose of ESOPs is to assume owners know what an ESOP is. I am not convinced many do.
ESOP stands for Employee Stock Ownership Plan, a type of qualified retirement trust. “Qualified” means the trust is irrevocable, has specific beneficiaries, and is subject to state law. (Note the third point especially, as it will come into play later on.)
Several popular notions about ESOPs prevail: ESOPs fundamentally benefit employees, are convoluted, make selling a business difficult, but yield tax savings. Two of these ideas are valid, and two are myth: ESOPs can indeed increase value for business owners and sellers, and are designed to avoid tax liability, but their complexity may not make them worthwhile options for certain companies.
Smart sellers often use ESOPs to maximize tax leverage during a transaction. An ESOP allows a seller to avoid paying capital gains on sale earnings, so long as the proceeds are reinvested in qualified securities. If you are able to save rather than spend the principal received, you essentially have tax-deferred sales proceeds: more money in the bank.
The math is simple. If you sell your company at $10 million at a capital gains rate of 20%, you walk away with the equivalent of a $12.5 million purchase price. In other words, you have $2.5 million in tax leverage on the transaction.
On the other side of the deal, the buyer gets a total deduction for the purchase price. Both parties benefit from the ESOP—the tax deduction vehicle. The buyer, paying $10 million for the company, could get a 30–40% deduction on the transaction. That means it could theoretically cost the buyer approximately only $6 million to put together a package valued at $12.5 million for the seller, and that kind of tax leverage is very difficult to ignore in the marketplace.
So, the buyer buys cheap, the company transitions to employees, the seller does not have to pay taxes on the transaction… What are an ESOP’s downsides? Why wouldn’t everyone take that opportunity?
There are two reasons.
First, you cannot sell without an appraised value for the business. The buyer must pay no less than the purchase price an appraiser puts in place. Sellers are thus limited by the market force valuation as determined by third parties, appraised value is not always commensurate with enterprise value. You may be surprised—as M&A advisors often are when we go to market—by how much a business is really worth.
Second, ESOPs are expensive. As I indicated above, states must regulate ESOPs, leading to paperwork and oversight costs. Sponsors and fiduciaries have to file annual reports and financial disclosure material, as well as respond to claims for benefits. As the National Center for Employee Ownership succinctly states, “To get the tax benefits ESOPs provide, companies must abide by the rules designed to make sure taxpayers are getting their money’s worth.”
For some buyers and sellers, ESOP are important tools to increase tax leverage, thus increasing sale value. For others, the reverse is true: an ESOP could decrease the sale price and place additional burdens on the buyer. What seems attractive and ends up as a benefit depends on your particular goals and circumstances.
ABOUT TED OFFIT
Ted Offit is a business lawyer, co-founder and Managing Principal of Offit Kurman Attorneys at Law. He serves as general counsel to a significant list of privately held organizations and often serves in an advisory capacity to the board of directors of the firm’s entrepreneurial clientele. He often serves as special counsel to businesses seeking to implement succession plans through a sale (merger and acquisition) or through transfers to affiliates (family members and employees). Mr. Offit also often serves as special counsel regarding the design and implementation of compensation plans for executive level staff. He can be reached at firstname.lastname@example.org or by calling 301.575.0304.
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