February 7, 2020
ESOP Transactions as a Succession Planning Solution
by Sherri Lazear, Lazear Capital Partners, Ltd.
There are approximately 77 million Baby Boomers in the United States. According to AARP, 10,000 Baby Boomers are turning 65 each day and this trend is expected to continue into the 2030’s. A recent survey found that approximately 75 percent of privately held businesses owned by Baby Boomers will be sold during the next 10 years.
Many owners are terrified by the thought of selling their businesses and are unable or unwilling to confront the reality of their age and need for liquidity. The owner’s identity is commonly intertwined with the company that they founded and led for decades. Owners fear the sale of their companies will leave them dispossessed of their leadership of the company and take away their “place in the world.”
Business owners are also concerned that a third-party purchaser may shut down operations or move them overseas and terminate employees. Consequently, many successful business owners put off performing any type of succession planning until it is too late, and death, disability or financial distress results in a sale of the company for less than fair value.
A sale to an Employee Stock Ownership Plan solves these problems. An ESOP is a qualified retirement plan for the benefit of the company’s employees. Rather than holding mutual funds, as is common in a 401(k) Plan, an ESOP primarily invests in the employer’s stock. The ESOP rules are set forth in the Internal Revenue Code and they provide two significant tax benefits:
- The owner may sell their shares to an ESOP and either defer or eliminate entirely the capital gain tax on the sale. This typically increases the seller’s net proceeds by approximately one-third as compared to any other buyer. For instance, if an owner could sell the company for $20 million to a competitor, they would net $15 million after capital gains taxes. With an ESOP, the owner could net $20 million.
- Since an ESOP is a retirement plan, all of the company’s post-ESOP earnings may be federal and state income tax free. This typically increases the company’s cash flow by approximately 50 percent. For instance, a company with $3 million in taxable income would pay approximately 33 percent in federal and state income tax ($1 million). With an ESOP, the income tax may be $0, for a savings of $1 million per year.
While the economic benefit of an ESOP transaction is obvious, many owners opt for a sale to an ESOP since it speaks to the two issues discussed above: a fear of losing their identity when they sell and a concern for their employees’ well-being under new ownership. A sale to an ESOP also enables the owner to continue to lead the company post-closing with operational control.
There are more than 7,000 ESOPs in the United States and approximately 8 percent of corporate equity is owned by ESOPs. The sale of a company to an ESOP works with numerous types of businesses such as:
- Consultancies, which sell time and advice
- Companies in which the material portion of the purchase price is contingent, usually based on future earnings
- C Corporations that sell assets
- Any business without a natural buyer
- Companies in which the intellectual capital of the employees is the true asset
- ESOP transactions are also ideal for manufacturers, distributors, companies in the construction industry, IT consultancies and staffing firms.
As the Baby Boomer generation continues to age and seek a means to obtain liquidity from their companies, an ESOP is an ownership transition tool that may provide them the greatest after tax proceeds while preserving their “place in the world” and their employees’ jobs.