Business owners are always thinking about the future of their companies, but how often does that thinking include succession planning? More than half of small to mid-size private companies do not have a succession or exit strategy in place. Many believe that succession is merely turning over the Company to a family member or eventually finding a third-party buyer, but increasingly there is another popular option that is frequently overlooked or misunderstood – selling the Company to its employees.
Selling to an Employee Stock Ownership Plan
Employee Stock Ownership Plans (ESOPs) can be an ideal and flexible exit strategy option for business owners. Depending on how the plan is structured, an ESOP can provide a variety of benefits that accrue to all stakeholders:
The owner can sell from 0% to 100% and receive a full and fair market value for the Company
The owner can elect to sell tax-deferred/tax free
The Company can operate tax-free going forward
The history, culture and legacy of the family and Company are preserved
Employees are given ownership in the Company over time – without investing a dime
Existing Sellers/Management can continue to run and control the operations of the Company
Key employees can realize significant economic benefits via Stock Appreciation Rights (SARs) and their participation in the ESOP itself
What is an ESOP?
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 his/her shares to an ESOP and either defer or eliminate the capital gain tax on the sale, thereby increasing the seller's net proceeds by approximately one-third when compared to any other type of sale. For instance, if an owner could sell the Company for $20 million to a competitor, he or she would net approximately $15 million after capital gains taxes. With a sale to an ESOP, the owner could net the full $20 million, or a $5 million increase.
Since an ESOP is a retirement plan, all of the Company's post-ESOP earnings may be federal and state income tax-free, significantly increasing the Company's cash flow. For instance, a Company with $3 million in taxable income would pay about 33% in federal and state income tax, or $1 million. With an ESOP, the income tax can be $0, for a savings of $1 million per year.
There are also personal benefits when selling a company to its employees. ESOPs are an especially attractive option for business owners who want their business to remain intact beyond succession while also rewarding loyal employees. For example, Kovatch Castings, Inc. (“KCI”), is an Investment Castings business in the Akron/Canton, Ohio area. In late 2019, Doug Kovatch, the 100% owner and the son of the founder, announced that he was transitioning the Company to Employee Ownership. KCI had grown from $4mm of revenues and 40 employees in 1991 to over 200 employees and $25mm of revenues as a leading participant in the Investment Castings industry. Doug's employees had been instrumental in helping grow the Company over the years while also cultivating a culture of safety, quality and support for the community. As Doug noted, "I had looked into the possibility of third-party sale, but one of my board of advisers suggested I consider an (Employee Stock Ownership Plan). The more I learned about it, the more an ESOP became sort of the clearest strategy to meet my goals."
For KCI and Doug, the ESOP not only fulfilled personal financial goals, but it secured existing employees' roles while providing them with an opportunity to participate in the future success of the business. "It allowed me to keep in place my managers, who share my vision for our future, keep the Kovatch name and hopefully have it continue for many more generations to come."
Structuring an ESOP
Any time you sell your business, there is no guarantee of the outcome. You can, however, follow some guidelines to set up yourself and your company for success by developing and establishing a solid structure. An ESOP can be incredibly flexible and structured to best meet the needs of the selling shareholders as well as current and future employees.
The complexity of a sale to an ESOP can vary by factors such as the number of owners or entities involved in the Company, the availability of reliable financial information, and the ultimate goals of the selling shareholders.
Is an ESOP a good choice for me?
It is essential to assemble the right team of advisors from the beginning who will help you choose the best path to achieve your personal and financial goals. Selling to an ESOP involves a number of professionals who have different expertise to address issues that may arise during the process. Pre-planning and having a qualified team in place to help guide you in choosing the right exit strategy for both you and your business can save significant time, money, and headaches down the road.
Bandit Industries, Inc., a leading designer and manufacturer of wood and waste processing equipment, chose the ESOP path after abandoning two previous attempts to sell the Company – once to another manufacturer and once to a private equity firm. “We realized neither was a good fit for Bandit, so we made the decision to sell to our trusted employees,” said owner Dianne Morey.
For Bandit, the ESOP ensured the corporate culture that had made Bandit a success for 35 years would remain intact. Owner, Jerry Morey, explains, "We have a very strong, dedicated dealer organization and a great crew, which is the key to our success. Our employees are experienced, smart and loyal to us, which is why we were so confident that an employee owned company would be the right fit for Bandit. All of our employees will have a stake in the Company."
Succession and exit plans are highly customized solutions. There isn't a template you can use for every business. However, experienced investment banking advisors will help you reach your goals by structuring and implementing the best succession planning strategy for your Company. An ESOP transaction may be the right solution for business owners who desire to create a smooth transition, retain a life of relevance, preserve their legacies and reward their employees.