Is An ESOP A Good Idea For You?

One of the most difficult problems for owners of closely held businesses is finding a way to turn their equity in a business into cash for retirement or other purposes. The decision to sell is more than an economic one, however. After putting years into a business, owners develop a strong feeling of identity with their company. At the same time, owners often have a sense of loyalty to the employees and would like to see them have a continuing role in the company. And, many owners don’t want to simply sell and move on. They would prefer to maintain some role in the company, ranging from active management to serving on the board or as an advisor.

For some business owners, the answer to these problems will be to turn over the company to an heir or sell to a competitor. But many owners do not have heirs interested in the business, and outside buyers are not easy to find. Even if they can be found, they may want to buy the company for its customer lists, technology, or facilities, or may just want to put a competitor out of business.

Olum’s, a 173-employee, four-store home furniture retailer in the Binghamton, NY area, found another solution. Back in 1989, the Olum family was looking to move on since none of them had an active role in the business. They could have sold to another company, but wanted a way to preserve the legacy of the company and reward the people who helped build it. An employee stock ownership plan (ESOP) proved the best answer. As a tax-favored employee benefit plan, it was able to borrow money to buy 75% of the company. In the late 1990s it acquired the remaining 25%. The plan was funded not by employees, but by tax-deductible corporate contributions.

This year, Olum’s celebrated its 100th year in business, making it one of the longest continually operating furniture retailers in the country. It is also the 25th anniversary of its ESOP. Wendy Howard, Plan Administrator for the ESOP at Olum’s, says the plan has made it possible for long-term Olum’s employees to accumulate substantial retirement assets. At the same time, Olum’s has been able to compete with new big-box discounters such as Sam’s Club and Lowe’s by offering outstanding customer service by its employee owners. Even during the recession, Olum’s was able to maintain its employment in a tough market.

Olum’s is not alone in the home furniture retail world. There are a few other companies with ESOPs, such as Hainje’s in Alabama and SleepTrain in California. There are also several office furniture retailers. But compared to other industries, ESOPs are not very common in furniture retail. There is no obvious reason for that other than that the idea of ESOPs tends to spread by example in industries in an idiosyncratic way. ESOPs are very common in supermarkets, for instance, and convenience stores. In both of these cases, the growth of ESOPs is likely the result of a few very well-known firms deciding to set the plans up and becoming models for other companies.

Although an ESOP is not a good fit for many companies, for many others it is an ideal solution to business transition. This article will look at how ESOPs work and how to determine if they make sense for you.

How Is an ESOP Used for Business Transition? With strong bipartisan support, Congress has intentionally made ESOPs the most attractive way to do business transition. An ESOP is a kind of employee benefit plan, similar in many ways to qualified retirement plans and governed by the same law (the Employee Retirement Income Security Act). An ESOP allows a company to set up a trust for employees and then use pre-tax future profits to buy out one or more owners on any schedule the company wants.  Redemptions of stock are not normally tax-deductible, but with ESOPs they are, making redemptions much cheaper. A $5 million business, for instance, would need about $8 million in pre-tax revenue to generate the $5 million to redeem shares. An ESOP only requires the $5 million.

Sellers to an ESOP can also defer taxation on the gain from the sale if the company is or converts to C status and the ESOP ends up with 30% or more of the stock and sellers reinvest in stocks and bonds of U.S. operating companies. If the ESOP is or converts to S status, the deferral does not apply, but any profits attributable to an ESOP are not taxable. A 30% ESOP company pays no taxes on 30% of its profits; a 100% ESOP company pays no taxes on any of its profits. Many ESOPs start off as C companies then convert to S.

There are rules, of course, to get these tax benefits. Stock is held in a trust. All employees with one or more years of full-time service must be in the plan and allocations must be based on relative pay or a more level formula, then distributed no later than five years after the end of the plan year the employee terminates or one year if the termination is for death, retirement, or disability. Distributions can be in installments of up to five years. Allocations must vest over not more than six years. ESOPs cannot be used to share ownership just with select employees, nor can allocations be made on a discretionary basis. There are only the most minimal required voting rights, ESOPs are governed by a trustee appointed by the board, and the trustee votes the shares for board elections and most other matters unless the company chooses to allow employees to vote.

Financing an ESOP. The simplest way to use an ESOP to transfer ownership is to have the company make tax-deductible cash contributions to the ESOP trust, which the trust then uses to gradually purchase the owner's shares. For instance, Kentwood Office Furniture in Grand Rapids, a 122-employee office furniture reseller, started an ESOP in 2012 by contributing cash to the plan to make an initial purchase in the next year. Alternatively, the owner can have the ESOP borrow the funds needed to buy the shares. In this way, larger amounts of stock can be purchased all at once, up to 100% of the equity, although banks are usually reluctant to loan for a full buyout all at once. For instance, in 2010 Sleep Train, one of the largest mattress retailers in the U.S., borrowed money to fund an ESOP to buy 25% of its stock. Many ESOPs start this way, transferring part of the ownership in an initial transaction, then buying the remaining shares some years later. Sleep Train has done a number of acquisitions of smaller mattress retailers since the ESOP as well, effectively including them in the ESOP too. Sleep Train has seen significant increases in their ESOP value since its inception.

Like Sleep Train, many ESOPs start out buying a minority of the shares. In some cases, they continue that way long term; in most cases, this is a first step towards eventual 100% ownership. Others just continue as minority ESOP owned companies.

Perhaps half of all ESOPs are funded instead by a seller note. The ESOP acquires the shares then pays back the seller at a reasonable rate of interest (not more than what a commercial lender would charge for loans of similar risk.) Sellers often like this idea because not only do they get their shares sold, but they get a reasonably good rate of return on the note. Seller notes also make it possible to sell the entire company all at once.

How Much Will the ESOP Pay? The price the ESOP will pay for the shares, as well as any other purchases by the plan, must be determined at least annually by an outside, independent appraiser. The appraiser's valuation will be based on several factors to determine what a willing financial buyer would pay. Discounted cash flow, expected future earnings, book value, the company's reputation, future market considerations, and other factors will be considered. A strategic buyer, such as a competitor, might pay an additional premium because when the target company is acquired, there are perceived operational synergies that make the target more profitable to the buyer than it would be as a stand-alone entity. The ESOP cannot match this price because it cannot generate these synergies. Sales to synergistic buyers do trigger capital gains taxes, however, and often come with numerous contingencies.

Who Gets How Much When and Other Key Rules: If you are willing to live with the rules for ESOPs, and an ESOP makes sense financially, then an ESOP may be the best way forward. But as appealing as an ESOP can be from a tax, legacy, and personal planning perspective, they are not right for every company. Several factors must, at a minimum, be present:

1. The company is making enough money to buy out an owner. The company must be generating enough cash to buy the shares, conduct its normal business, and make necessary reinvestments.
   
2. If the company is borrowing to buy the shares, its existing debt must not prevent it from taking out an adequate loan. 
   
3. If the seller wants to take the tax-deferred rollover, the company must be a regular C corporation or convert from S to C status. S corporations can establish ESOPs, but their owners cannot take advantage of the tax-deferred rollover described above.
   
4. The seller(s) must be willing to sell their shares at fair market value, even if the ESOP pays less than an outside buyer would. An ESOP will pay the appraised fair market value based on what a willing financial buyer would pay based on a variety of factors. Sometimes an outside buyer can pay more for a company if it has a particular fit that creates synergies that go beyond what the company is worth on its own. If that price nets the seller more than what would be achieved on an after-tax basis selling to an ESOP (remember, the seller can defer gains on the ESOP sale but not a sale to a third party), then an ESOP only makes sense if the non-financial benefits of the selling this way outweigh the financial difference.
   
5. Management continuity must be provided. Banks, suppliers, and customers will all want to be persuaded that the company can continue to operate successfully. It is essential that people be trained to take the place of departing owners to assure a smooth transition.
   
6. You must be willing to deal with costs and complexity: ESOPs do require more management time to make sure you understand how they work. The costs of setting up a plan will typically run from $70,000 to $100,000 for “plain vanilla” plans and higher for more complex ones or lager companies. That is substantial, although the costs (including brokerage fees) for selling a third party are higher. These costs, however, typically make ESOPs prohibitive for companies with roughly 15 or fewer employees. While ESOPs can be complex, sales to other companies are usually just as complex or more so and often involve unwanted contingencies, such as earnouts or extended escrows.

If you do decide to pursue an ESOP, make sure you get qualified advice. Lots of people will tell you they are ESOP experts, but a much smaller number are. The National Center for Employee Ownership maintains a referral service of people experienced in this field.

About Corey Rosen: Corey Rosen is the founder of the National Center for Employee Ownership, a nonprofit information, membership, and research organization. Details on ESOPs can be found at www.nceo.org.