Eric Pritchard is a partner in Kleinbard Bell & Brecker LLP, Philadelphia. The firm focuses on acquisition and succession strategies.
One of the challenges owners of closely held companies face is finding a way to transition away from their businesses—to take a smaller role, retire or sell a business that may have been the focus for a substantial portion of their working lives. Owners want not only the economic rewards of a lifetime of work, but they may also have developed strong feelings of identity with their companies, as well as a sense of loyalty to employees and customers. Stable exit, with continuity of management and customer service may be as important as fair market value and liquidity. These may be hard to guarantee with outside buyers, who may want to acquire the company for its assets and accounts, or who may just want to eliminate competition. Some advisers also predict that, as Baby Boomers retire in record numbers, the increased supply of family-owned or closely held businesses for sale may outpace demand, potentially causing depressed purchase prices and longer timelines for sales.
ESOPs (employee stock ownership plans) can be an effective–and tax-efficient–succession alternative. Transitions can be effectuated all at once or gradually, for as little or as much of the stock at a time as the owners prefer, allowing owners to remain with the company in whatever capacity they want and for as long as they desire before ultimately selling control. ESOPs are advantageous for employees, since they receive shares in their company without paying directly for the owner's shares. ESOPs can provide employees significant incentives to excel at their jobs. Changes in corporate control and management can also be minimal. While trustees vote the shares in the ESOP, boards appoint those trustees, so both can work together to promote corporate culture. The board and management continue to run the company and can decide what level of input employees should have, and customer service need not be affected at all.
ESOPs have other benefits as well as challenges. Here’s a rundown of the basics:
An ESOP is a qualified benefit plan—similar to a profit-sharing plan—designed to invest primarily in the stock of the employer company. The company sets up a trust into which it may contribute cash to buy existing or new shares of stock. The plan can also borrow (typically from the company) to buy new or existing shares. The company then makes cash contributions to enable the plan to repay the loan. Regardless of how the ESOP acquires the stock, company contributions to the trust are tax-deductible (within certain legal limits). The plan owns the stock for the benefit of the company’s employees. The stock is allocated to employees on an employer-determined basis (in most cases, the ratio of an employee’s compensation relative to the company’s payroll).
Transitioning of control
In addition to allowing owners to facilitate a transition of control at the pace they desire, ESOPs permit a seller to self-finance a stock sale, even in a challenging credit market. ESOPs also offer potentially significant tax advantages, both to owner-sellers and to the companies. In certain circumstances, the seller can defer the capital gains on the sale of stock and the company owned by the ESOP may enjoy a substantial reduction in federal income taxes. Let’s not forget, too, that ESOPs are also company-funded employee benefits that both motivate employees to make their companies more profitable (and ultimately more valuable) and may inspire employee loyalty—an important factor in our highly competitive industry. ESOPs are not just for small or closely held companies, either. They exist in companies across geographic and size spectrums.
Is an ESOP right for your company? It could possibly be. If you think you have an interest in pursuing an ESOP, you need to find counsel who specializes in these transactions since an ESOP requires in-depth understanding of the applicable tax laws. One misstep could be costly and diminish the effect of the ESOP’s benefits. While ESOPs can be very effective succession vehicles, they are not one-size-fits-all solutions.