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ESOP Opportunities White Paper

An Employee Stock Ownership Plan (ESOP) taxes on the sale. The article painted a picture
is a tool business owners use to achieve three far too good to be true, but he deemed it worth
common Exit Objectives: a phone call to his crusty old law firm. This
1. To leave the business soon; White Paper describes “the rest of the story.”
2. To leave the business with cash
adequate for financial security; and Employee Stock Ownership Plan
3. To leave the business to employees. ESOPs have received a lot of favorable press
lately. It is almost as if an ESOP is the modern-
Let’s look at the case of Steve Victoria, sole day equivalent of a diet pill that lets folks eat all
owner of Victoria Engineering and Consulting, they want and still lose weight.
Inc. (VECI).
VECI was a 35-person firm with annual ESOPs are touted as allowing business
revenues of $5 million and annual cash flow of owners to cash out at fair market value from
$500,000. Steve explored the sale of his their businesses, pay no taxes on the sale and,
company to an outside third party, but, after his in the process, transfer their companies to their
business broker’s investigation, it appeared employees. To separate truth from fiction - or
that a cash sale was unlikely. reality from hype - business owners need to
ask the following questions:
Steve’s second choice — to sell VECI to his What is an ESOP?
employees — was problematic because he How does an ESOP buyout work?
knew they lacked the ability (and, perhaps, the What company characteristics are
willingness) to obtain meaningful financing. needed to make an ESOP work well?
Steve was unwilling to leave VECI in the hands What are the disadvantages to an owner
of his employees — no matter how capable of in selling to an ESOP?
running it they might be — without the majority What are the advantages to an owner of
of the company’s value converted to cash and selling to an ESOP?
stowed safely in his pockets. There seemed to
be no way out. He was stuck in his business. This White Paper explores each question and
will help you make sense of the hype and of
Steve’s only exit appeared to be to diminish his the confusing technical requirements
involvement gradually in the hope that VECI surrounding ESOPs.
could continue to distribute earnings to him.
WHAT IS AN ESOP?
Then Steve read an article in an airline travel ESOPs are qualified retirement plans, typically
magazine that presented an appealing profit sharing plans, which must invest primarily
alternative: He could cash out for fair value, his in the stock of the sponsoring employer (in
employees could own VECI, and — the your case, the sponsoring employer is
frosting on the cake — he would pay no your business). As such, ESOPs must

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follow all requirements of governing law, transaction contains the following parties:
including: 1. The company that contributes cash to its
All full-time employees eventually ESOP.
participate in the plan. 2. The ESOP that uses the tax deductible
Each participant is allocated a share of contributions to acquire the owner’s
the plan assets in proportion to stock.
compensation. 3. The owner who transfers his stock to the
Full vesting of benefits cannot exceed ESOP in return for cash. If this
six years from date of participation. transaction meets certain qualifications,
Upon termination of employment, the the cash that the owner receives is not
plan must give the participant the right taxed to him. In this scenario available
to receive his or her account balance in cash flow of the company is contributed
cash over five years. on a tax-deductible basis to an ESOP
Contributions to the plan by the which pays that cash to an owner who
company are tax deductible and the may be able to receive payment without
plan does not pay income tax on income paying any taxes provided certain
it earns. Eventually, participants pay an requirements are met.
income tax when they terminate 4. A bank. Since most owners want as
employment and receive a cash much cash up front as possible when
distribution from the ESOP (unless they sell their stock, a financing source
rolled over into an IRA). is usually required which will loan
The chief difference between an ESOP money to the ESOP that in turn uses the
and a regular profit sharing plan is that loan proceeds to acquire the owner’s
ESOPs must invest primarily in the stock.
stock of the company sponsoring the 5. The loan is repaid from the company’s
plan. future contributions to the ESOP or
An ESOP can receive contributions of dividend payments from the stock
stock or cash from the company. If it owned by the ESOP.
receives cash, that cash can be used to
purchase stock from the owner of the At this point, the employees/participants have
company. become, at least indirectly, the new owners of
An ESOP may borrow funds (a the company. Their interests will need to be
“Leveraged ESOP”) to acquire stock protected throughout the transaction.
from the owner of the company.
WHAT COMPANY CHARACTERISTICS ARE
HOW DOES AN ESOP BUYOUT WORK? NEEDED TO MAKE ESOPS WORK WELL?
As the chart below illustrates, in its ESOPs are not for every business. To be
simplest form, an ESOP buyout successful a company should have the

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following characteristics: include the company, the trustee and the
Strong cash flow; individual members of a committee appointed
Good management team to carry on to administer the ESOP) must be certain that
after the owner has left; the ESOP transaction is undertaken for the
Little or no permanent debt; benefit of the participants and their
Relatively large payroll base (but not beneficiaries. Furthermore, ESOP fiduciaries
always); should hire independent legal and financial
Alignment of shareholder and employee advisors to advise them on the structure and
interests; and appropriateness of the purchase of stock from
Adequate capitalization to sustain future the owner. Owners can and should minimize
company growth. their fiduciary risk by letting others serve as
ESOP trustees and by making certain that
If your business lacks any of these those trustees exercise independent judgment
characteristics, especially the first three, it is and seek advice from experienced advisors.
unlikely that an ESOP is the best path for you.
Repurchase Requirements
WHAT ARE THE DISADVANTAGES TO AN When a participant terminates employment, the
OWNER OF SELLING TO AN ESOP? company (or the ESOP) must repurchase the
departing employee’s stock over a five-year
Cost period. This “repurchase liability” will eventually
ESOPs are costly to establish and relatively be significant as employees retire and leave
costly to maintain over the years; in many the company. To fund this liability the ESOP
respects the sale of stock to an ESOP is more must receive additional cash contributions from
complex and almost as expensive as a sale to the company or the company must buy back
an outside third party. The fees for a Leveraged the stock directly from the departing
ESOP buyout of an owner range, from $25,000 participant.
to $100,000. In addition, to establish an ESOP,
at least one arms-length, third party appraisal Pre-Funding
is needed (at a cost of $10,000 to $20,000, or Pre-funding of an ESOP by the company is
more). An annual update to the appraisal is normally required. A bank is not going to lend
also required at a cost of several thousand 100 percent of the purchase price of an
dollars. owner’s stock. With a strong balance sheet,
banks might lend 60 to 70 percent of the
Fiduciary Responsibilities purchase price. Consequently, companies
The fiduciary responsibility requirements of the often pre-fund the ESOP by making
Employee Retirement Income Security Act of contributions during the one to three years
1974 (ERISA) are significant. The before the intended stock transaction.
fiduciaries of an ESOP (which typically This pre-funding serves as the ESOP’s

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“equity” in the purchase making the bank or Tax Treatment
financial institution far more likely to lend the The payment of both principal and interest to
balance of the purchase price. Keep in mind fund a purchase by the ESOP can be
that pre-funding the ESOP uses monies that accomplished with pretax rather than after-tax
otherwise could have been bonused directly to dollars. Remember, the company makes tax-
the owner. deductible contributions to the ESOP or, in the
case of a “C” corporation, dividends paid on
Employee Skepticism stock owned by the ESOP to repay the loan
It surprises some owners to learn that key are considered tax deductible.
employees often view the ESOP as a
disincentive. These key employees must run If the ESOP purchases stock from the
the company and assume the responsibility of shareholder of a C corporation, and after the
ownership without reaping 100 percent of the sale the ESOP owns at least 30 percent of the
reward. As part of the ESOP buyout design, it outstanding stock of the corporation, the selling
is normally prudent to create an equity or cash shareholder will not be taxed on the proceeds
incentive program for the management group. as long as they are invested (generally
Doing so allows them to acquire equity or other speaking) in U.S. stocks and bonds (not mutual
financial reward outside of the ESOP as a funds).
reward for their efforts on a go-forward basis.
Of course, when those replacement securities
Collateral are sold, a capital gain is generated, the size of
A financial institution usually requires collateral which is determined by the owner’s basis in the
as a condition of making a loan to the ESOP. stock sold to the ESOP. To avoid this tax
Usually, this collateral includes, at least for a treatment, owners can hold on to those
time, the departing owner’s replacement replacement securities until death when, the
securities he has purchased with the proceeds securities receive a step-up in basis and can
of the sale of his stock to the ESOP. be sold free from any capital gain.

ESOP uses available Cash Flow Few owners, however, aggressively pursue this
Finally, allocating the bulk of the available cash capital gains tax-saving opportunity. Instead,
flow of the company to ESOP contributions in they invest the proceeds from the sale of stock
order to repay the financing costs of acquiring to the ESOP in high-quality floating rate bonds.
an owner’s stock can hinder the ability of the As long as these bonds are not sold, no capital
company to grow. gains tax is incurred. The owner can use these
bonds as collateral to obtain a loan from any
WHAT ARE THE ADVANTAGES TO AN number of brokerage houses or other financial
OWNER OF SELLING TO AN ESOP? institutions. The interest rate for the loan
will be less than one hundred basis

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points greater than the interest paid by the strategic buyers.
bonds. The proceeds from this loan can then
be invested in a variety of stocks and bonds, or The tax benefits of a Leveraged ESOP buyout
simply spent — all without any tax are such that the cash flow of the company can
consequence. be captured before it is taxed and used to
finance the purchase the owner’s stock. A
When the reinvested asset is sold, a capital combination of ESOP pre-funding and
gain is generated but only on the difference borrowing from a bank (or other financial
between the sale price and the purchase price. institution) puts the owner in much the same
Combining the deferral of gain on the sale of position as if he had sold to a third party for
stock to an ESOP with the purchase of long- cash — except it allows employees to be the
term bonds used as collateral can mean that new owners.
the business owner permanently avoids capital
gains tax on the sale of his stock to the VECI CASE STUDY
company’s ESOP. Let’s return to Steve Victoria and VECI to see
how Steve and his advisors dealt with the
Stimulate Company Productivity many issues surrounding the creation of an
In addition to the tax treatment advantages, an ESOP. Like any other Exit Planning path,
ESOP holds the potential for productivity gains Steve’s advisors insisted:
in the company. According to an article in That he set objectives;
Nation’s Business (Volume 85, 1997), “In a That he determine a business value;
survey of 1,150 ESOP companies in 1995…68 That the value of the business be
percent of the respondents said their financial promoted and preserved through
figures improved the year after they instituted motivating and keeping key employees;
an ESOP and 60 percent said productivity That the contemplated Exit Plan, in this
improved.” case an ESOP, be well-planned and
implemented;
Cash to Owner That business continuity be considered
A leveraged ESOP buyout puts cash in the should Steve not survive until he sells
owner’s pocket. Other than a sale for cash to the stock; and
an outside third party, the ESOP is the best That Steve’s family be protected in the
way to maximize the amount of cash at closing. event of Steve’s death.
Owners with businesses worth three to ten
million dollars often cannot attract cash buyers. Now that we understand how an ESOP met
These businesses have strong cash flow, a Steve’s objectives, we will review the first four
superior management team, and a bright steps on his Exit Planning path.
future. Yet, they are too small to attract
the interest of financial, institutional or STEP ONE: FIXING EXIT OBJECTIVES

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Briefly, Steve was willing to remain with the incentive plan to motivate his three key
company for an additional two or three years. managers to remain with the company after
When he left the business, he wanted cash Steve’s departure. Why? Once Steve left,
sufficient to achieve financial security. He and VECI’s continued success depended upon a
his advisors determined that he needed to net core group of key employees who had the
$2 million (after taxes) from the sale of his experience to operate, manage and grow the
interest to the ESOP. Lastly, Steve had a company. Continued success was vital.
strong, but not overwhelming, interest in Without it, the company would not be able to
transferring the business to his employees, generate sufficient income to pay Steve for his
especially to his key employees. stock via the ESOP or to repay any bank loan
used to finance the purchase of Steve’s stock.
STEP TWO: DETERMINING BUSINESS Also, as we’ve seen, Steve’s appraiser
VALUE confirmed that the value of VECI could not be
As Steve was determining his Exit Objectives supported unless Steve provided for the
he also hired a valuation expert, experienced in continuity of management after the sale to the
ESOP valuation, to obtain a preliminary ESOP and Steve’s departure. Without the core
company value. Steve did not request a formal group active and motivated, the company’s
valuation at this time. Instead, he was value would have to be adjusted downward.
interested only in knowing if the business could
be sold for an amount of money sufficient to It is important for owners to understand that
meet his financial security objectives ($2 key employees, for the most part, are unwilling
million after-tax). He knew that a formal to work and act like owners unless they are
valuation would come later as part of the owners to a “significant” degree. Every
ESOP sale process. The appraiser thought that company and every group of key employees
VECI was worth approximately $2.5 million, a define significant slightly differently but
value in excess of Steve’s minimal financial generally all key employees want to have more
needs (absent any taxation); provided ownership than they are eligible to receive as
management would continue with the company participants in the ESOP. They will insist upon
after the sale to the ESOP. The appraiser additional stock or equivalent incentives.
would have significantly discounted the value
of the company in the absence of preexisting Meeting this demand is problematic because
key employee incentive plans. their ownership and the price they pay for it
must be similar to the ownership and price of
STEP THREE: KEEPING EMPLOYEES ON stock sold to the ESOP. If not, the ESOP
BOARD participants can rightfully object to the
With his objectives set and valuation in hand, favorable deal the key employees receive.
Steve and his advisors knew it was
imperative to develop a key employee Key employee incentives then, must be

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part of the initial design of the owner’s exit departure date.
plan. These key employee incentive plans can
either be stock-based or cash-based — the By creating the ESOP before the expected sale
promise of an additional bonus if the company date, VECI could make annual contributions to
performs pursuant to an agreed upon standard. the ESOP on a tax-deductible basis. This
In Steve’s case the employees enabled the company to contribute almost
were most interested in actual stock $750,000 to the ESOP in the three years prior
ownership. to the sale. This pre-funding, in turn, provided
the ESOP with sufficient cash to pay almost 40
Consequently, the company devised a stock percent of the purchase price of Steve’s stock.
option plan in which each of the three key It was anticipated that a bank would lend the
employees would be able to receive 10 percent ESOP the balance of the purchase price.
of the outstanding stock of the company as
well as cash bonuses to pay for the exercise of Steve could have pursued a different strategy
the stock option plan. The key employees’ right using the ESOP. He could have sold the stock
to exercise their stock options is delayed until using an installment note to the ESOP and
Steve’s stock had been purchased and paid for initiated his exit immediately, although bank
by the ESOP. financing would, in all likelihood, be
unavailable. Alternatively, he could have
STEP FOUR: THE DESIGN AND elected to sell less than all of his stock to the
IMPLEMENTATION OF THE ESOP ESOP improving the possibility of bank
PURCHASE financing.
First, VECI’s attorneys reviewed an ESOP
prepared by an experienced third party For example, Steve might have been able to
administration firm that specialized in ESOPS. sell 30 to 40 percent of his stock and the
It provided that all employees who worked ESOP may have been able to obtain bank
1000 hours or more became participants after financing for the purchase.
one year of service. The plan further required
that each participant work five years before Steve opted for a complete exit after three
becoming fully vested in a share of the plan years during which the ESOP was pre-funded
assets. The co-trustees of the ESOP would be with dollars which could otherwise have been
one of the key employees and a local bank bonused to him.
familiar with the administration and fiduciary
responsibilities of ESOP trustees. Steve’s The responsibility to obtain bank financing
advisors stressed the importance of protecting ultimately rested with a committee appointed
himself by using independent trustees. The by the ESOP trustees. It was their
ESOP was to be funded with cash for responsibility to obtain and to analyze
three years before Steve’s expected loan proposals before selecting the most

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appropriate lender for the ESOP. fiduciary obligation or duty to the ESOP and its
participants. No departing owner wants the
Although Steve did not serve on the ESOP specter of future litigation looming over him.
committee, he was — much to his chagrin — Owners can avoid this exposure by realizing
involved in the financing. As a condition of that when creating an ESOP, they have
financing for the remaining purchase price, created a separate buyer; a buyer who will
every bank insisted that Steve pledge his sale want to make (and must make) independent
proceeds as security. and informed decisions. This buyer will use its
own set of advisors including an appraiser, a
Recall that one of the advantages of selling to financial advisor, a transaction attorney and
an ESOP is that the owner is not taxed on the perhaps a CPA — the same advisors owners
sale proceeds provided he or she acquires use to make an informed decision to sell to an
appropriate replacement securities. These ESOP.
publicly-traded, liquid securities are generally
blue chip bonds or stocks and are a lender’s CONCLUSION
first choice for collateral. Through determined The decision to sell your stock using a
negotiation, Steve’s advisors reduced the Leveraged ESOP is neither easy nor
collateralization period and minimized the inexpensive. Yet, it is no more difficult or
amount of securities Steve was required to expensive than selling your business to an
pledge. In the end, Steve pledged 50 percent outside third party.
of the sale proceeds to be released as the loan
was repaid. If that third party cannot be located, or is
unacceptable to you, or if you wish to provide a
CAUTION benefit to your employees in the form of
Finally, a word of caution to owners who are indirect ownership in your company, an ESOP
considering using an ESOP as part of their exit can be a most attractive buyer. As you evaluate
strategies. The sale of an owner’s stock to an the many different ways of leaving your
ESOP involves more than simply making sure business in style, consider the ESOP as yet
the owner’s Exit Objectives are met. A sale of one more opportunity to achieve all of your Exit
stock to an ESOP must be an arm’s length Objectives.
transaction between the selling owner and an
independently directed and administered ©2007 Business Enterprise Institute, Inc.
ESOP.

If an owner makes decisions for the ESOP
regarding the purchase or financing of his
stock, he exposes himself to allegations
and lawsuits claiming a breach of

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