The Latest Word on ESOPs: What We All Need to Know
Has the new federal tax regime set forth the grounds to reconsider an ESOP?
An ESOP is a qualified retirement plan that can use debt financing to buy company stock from the companyâ€™s owner(s). Itâ€™s a serious option for any business owner who wants to liquidate some or all of his or her ownership. Martin Staubus reviews how ESOPs work, as well as the benefits they provide to buyers (employees) and sellers (owners).
â€śIt ainâ€™t what people donâ€™t know that worries me; itâ€™s what they think they know that just ainâ€™t so.â€ť
Mark Twain?Â Will Rogers?Â Surprisingly enough, no one actually seems to know who first uttered those words.Â (See http://wellnowbob.blogspot.com/2008/07/it-aint-what-you-dont-know.html)Â Whatever the source, itâ€™s a sentiment that fits when it comes to ESOPs.
Yes, most of us in the financial advisory community know that an ESOP (employee stock ownership plan) is a qualified retirement plan that can use debt financing to buy company stock from the companyâ€™s owner(s).Â So, it is an option for any business owner who is thinking about selling all or part of his or her company.Â Beyond that, the knowledge base starts to run dry for many.Â Rumor has it, for example, that an ESOP only works in a very large company, or just a small one.Â Some think it means the employees will take over and make crazy decisions that will ruin the business.Â Others assume that the price an ESOP will pay isnâ€™t competitive with what the seller could get from other buyers.Â In fact, none of these notions are true.Â The last one,however, bears some investigation.
It is true that an ESOP can pay only the fair market value (on a financial investment basis) for any stock it buys, as determined by an independent professional appraiser hired by the company.Â Thus, an ESOP cannot match a purchase offer from a strategic buyer that includes a premium over the fair market value on a financial basis, but thatâ€™s not the end of the story.Â An individual who sells C corporation stock to an ESOP is permitted to defer all of his or her capital gain indefinitely by reinvesting the sales proceeds in other investment securities (more on this later).Â On an after-tax basis, is a business owner still likely to do better taking a strategic buyerâ€™s premium, or is the untaxed sale to an ESOP the better deal?
As it happens, a study of this question was performed by Acclaro Valuation Advisors, an Omaha investment advisory firm, using data from the 2012 FactSet Mergerstat/BVR Control Premium Study (â€śMergerstatâ€ť).Â The results were interesting.Â It turns out that, prior to this year, in the majority of cases, sellers were likely to do better (depending on the industry) by taking a strategic buyerâ€™s premium than by selling to an ESOPâ€”even after factoring in the tax savings available with a sale to an ESOP (though ESOPs were more competitive in high-tax states like California and New York).
As they say, that was so last year.Â With the significant increase in the total applicable taxes on long-term capital gains now in effect for 2013, the pendulum has swung the other wayâ€”even in low-tax states.Â Â In fact, of the 50 industries examined by Acclaro, only eight saw sales premiums that would leave a seller better off after taxes than from selling to an ESOP.Â In the other 42 industries, sellers will now do as well or better by selling to an ESOP.Â Aside from the issue of price, there is much more to like about selling to an ESOP.
With this in mind, an ESOP is a serious option for almost any business owner who wants to liquidate some or all of his or her ownership.Â So itâ€™s worth understanding at a fuller level.Â Iâ€™m here to help with that.Â
Okay, So Whatâ€™s an ESOP?Â
Technically, an ESOP is simply a qualified retirement plan, not unlike a 401(k) or retirement profit-sharing plan. Â In actual use however, it is much more.Â The function of an ESOP is to buy company stock, and then hold it as a retirement investment for the employees.Â To facilitate this, ESOPs are authorized to borrow money to finance the purchase of stock.Â So, if you own stock in a private corporation, an ESOP means that you always have a way to sell that stockâ€”whether just a few shares, a major portion or the whole interest.
How Does It Work?Â
To establish an ESOP, the ownerâ€™s process is straightforward:
- Step 1:Â have a lawyer draw up the paperwork to create an ESOP.
- Step 2:Â hire an independent business appraiser to determine the stockâ€™s fair market value (by law that sets the sales price).
- Step 3:Â arrange the financing: either a bank loan to the ESOP so it can pay cash or an agreement that the ESOP will pay in installments (or some of both).
- Step 4:Â hand over a stock certificate to the ESOP and receive cash and/or a note in exchange.
- Step 5:Â as the ESOPâ€™s debt payments come due, the company makes tax-deductible contributions to the ESOP so the ESOP can make its payments to the bank or the seller.
What Are the Benefits?Â
Selling stock to an ESOP offers some remarkable advantages.Â These include:
1) Big tax advantages. Â A sale to an ESOP can produce tax savings that equal the entire price of the stock sold to the ESOP.Â The tax savings are as follows:
- The company.Â Corporate expenditures to redeem stock are not tax-deductible, but with an ESOP, they are.Â Â Depending on the applicable state income tax rate, this deductibility may save about 40 percent of the transaction cost.
- The seller.Â Â When you sell to an ESOP, you can avoid paying the capital gains tax that would ordinarily be due by electing the deferral available under code section 1042.Â With the new rates now effect, this may save you more than 33 percent of your proceeds.
- The employees.Â Â If you give employees stock as a form of incentive compensation, that stock is taxable to the employee as compensation.Â By awarding stock via the ESOP, it is not.Â Employee tax rates vary, but most pay at least 35 percent combined state and federal.
Totaled up, the tax savings on a sale of stock to an ESOP may exceed 100 percent of the value of the stock.
Â 2)Â The ability to sell a portion of a company. Â With an ESOP, you can sell any portion of the company you want.Â The ESOP will pay full market value for any amount.Â This helps in a number of situations:
- The company has more than one owner, and one wants out while the other(s) wants to keep everything going.Â Answer: buy out that person with an ESOP.
- The owner isnâ€™t ready to walk away yet, but with so much of his net worth tied up in an illiquid, at-risk investment, he or she is concerned about some worrisome â€śwhat ifs.â€ťÂ Solution: take some value off the table and gain financial security by cashing out a portion while continuing in control and owning the balance.
- The owner is getting burned out from the daily grind, but doesnâ€™t want to quit entirely.Â Answer: sell part of the ownership to the ESOP.Â Employees will then be motivated to help the business, so they can be trusted to â€śmind the store,â€ť allowing the owner to reduce his work time.
3) No adversarial buyer across the table.Â You get sole control over the deal.Â Set up a sale when you want, in the amount you want.Â Do what you want to do, not what an adversarial buyer is demanding.Â Among the many advantages this brings, two stand out: 1) if you decide to sell to an ESOP, the deal will almost certainly happen, whereas if you begin negotiating a deal to sell to a conventional acquirer, a good 75 percent of the time, those negotiations will end in failure, requiring you to find a new suitor and start over; and 2) because of the lack of adversarial contention, the transactional costs of selling a company to an ESOP are substantially lower than the costs of a conventional M&A deal.
4) An opportunity to leave a legacy.Â Selling to an ESOP means that the company will continue on as a thriving, independent venture.Â This can be very gratifying to a selling owner. Â Most have worked long and hard to build their company, and it means something to know that the business will not be liquidated or merged out of existence.Â It also means something that the employees who have helped the owner for many years will have the opportunity to keep their jobs and get a chance to make a go of it on their own.Â Itâ€™s a â€śhappily ever afterâ€ť story for everyone.Â
Martin Staubus is the Executive Director of the Beyster Institute, a center of expertise on employee stock ownership based at the University of California, San Diego.Â Martin has advised hundreds of companies on the effective deployment of ESOPs.Â For more information, go to http://www.rady.ucsd.edu/beyster/ or contact Martin Staubus at firstname.lastname@example.org.