If you are considering selling your business, you may often believe that the only available option is selling to an unrelated third-party buyer, such as a competitor or a private equity fund. You may be concerned about how any such buyer will operate the business after the consummation of the transaction, as well as the impact such a sale will have on your current employees. You naturally want to pick the route that is best for the future of the company you worked so hard to develop and grow, while also protecting the interest of the employees who may have been with your business for many years.
An Alternative Exit Strategy: Selling to an ESOP
Many business owners have little knowledge of the possibility of selling their business to an Employee Stock Ownership Plan (“ESOP”). In certain situations, an ESOP can be an extremely attractive exit option that allows you to sell all or a portion of your business to your employees. An ESOP is a tax-qualified retirement plan that is allowed to hold employer securities as an investment for the benefit of the employees of the selling company. Use of an ESOP structure provides a succession plan that allows a business owner to avoid selling their business to a third-party entity.
How an ESOP Works
Under an ESOP structure, stock is acquired by the ESOP from you and is then transferred and allocated, over a period, to the employees of the company. Further, the use of an ESOP as a business succession tool can also provide significant tax benefits to both you and the company.
So, the question becomes: Would utilizing an ESOP structure make the most sense for you and your business?
It should be noted that there are benefits to both selling to an outside third-party buyer or selling to an ESOP. Ultimately, your decision will likely depend on your goals in transitioning out of your business.
Benefits of Selling to an ESOP
If your goal is to benefit your employees and slowly integrate out of the operations of the business, selling to an ESOP might be for you. Some of the benefits of selling to your employees and taking the ESOP route include, but are not limited to:
- Protecting Loyal Employees: Your employees will not have to worry about possible layoffs if a third-party entity purchases the business or a change in the culture of your business.
- Corporate Tax Benefits: If the business is structured as an S-Corporation or converts to an S-Corporation, the revenue earned by the business will not be subject to federal taxes after the business is sold to an ESOP since the revenue will pass-through to a tax-qualified retirement plan. Thus, the revenue of the S-Corporations may be shielded from up to 100% of income tax liabilities, depending on how much of the company is employee-owned through the ESOP.
- Personal Tax Benefits: Under Section 1042 of the Internal Revenue Code, if your business is structured as a C-Corporation, you can defer the capital gain taxes on the sale of your stock to an ESOP if the ESOP owns at least 30% or more of the company after the transaction and you invest the proceeds from the transaction in “qualified replacement property” (such as stock, bonds, etc.). In addition, if you retain the proceeds in qualified replacement property until your death, the proceeds of the sale to ESOP will transfer tax-free to your heirs.
- Sale Price Considerations: In addition to possible tax benefits, in certain situations you might make more money from the sale of your business to an ESOP. The sales price to an ESOP is based on fair market value, whereas outside buyers may offer and negotiate a discounted sales price.
- A Gradual Transition Out of the Business: You can remain involved in business operations and slowly transition out of your involvement with the business by selling to an ESOP.
On the other hand, some business owners will not be interested in a sale to an ESOP. The above benefits of an ESOP transaction may not fully align with your goals in selling the business. You may believe that you can sell your business for a premium that may exceed the fair market value of the business. Further, you may have a strong desire to immediately terminate your involvement with the business and head into retirement. If so, the gradual transition offered under an ESOP arrangement is not preferable.
Benefits of Selling to a Third-Party Buyer
If you want to quickly exit your business for as much money as possible, selling to a third-party entity or private equity firm might be the preferred route. Some benefits of selling to an outside buyer include:
- Potential for a Higher Purchase Price: A third-party buyer may be willing to pay more than fair market value for the company. There could be a pool of potential buyers which may create competition among interested parties and raise the sales price to an amount higher than fair market value.
- Quicker Access to Sale Proceeds: Sale to an outside buyer often occurs in a lump sum amount that is payable upon the closing of the transaction, so you will have the sales proceeds quicker than you would if you were to pursue the ESOP route.
- A Clean Break from the Business: You can experience a definitive end to your involvement with the business, as the sale to an outside buyer can be structured to immediately terminate your business involvement. If you do not wish to continue involvement with your business or entertain some type of phased retirement, selling to an outside buyer may be preferable.
Evaluating Your Business Succession Options
If a business sale is on your horizon, now is the time to begin evaluating the succession strategies available to you. Understanding the advantages and potential drawbacks of both ESOP transactions and third-party sales can help position you to make an informed decision when the time comes. Buckingham’s attorneys can guide you through the available options and help you create a transition plan designed to achieve your financial and personal goals.
To further explore whether an ESOP may be the right fit for your business, join us for our Breakfast with Buckingham: Using an ESOP as a Business Succession Tool. This educational event will provide valuable insight into the legal, tax, and practical considerations of ESOP transactions. Learn more and register here.