You’ve built a successful business, but you’ve begun thinking about an eventual exit. You could sell, or pass the business to a family member, but that could create uncertainty. For owners who want to preserve their legacy, and the jobs of their employees, an Employee Stock Ownership Plan could be the answer.
An ESOP not only gives employees a vested interest in the business, increasing productivity, it also generally provides owners with a fair market value for the business, says Kevin Ward, senior vice president, middle market commercial banking at Huntington. The owner may also receive capital gains tax benefits and interest income from financing a portion of the sale through seller notes. Employees, meanwhile, stand to realize a retirement benefit well in excess of that of nearly any other available plan.
Here’s how to determine if an ESOP is the right option for you and your business.
What is an ESOP, and what companies qualify?
An ESOP is a qualified retirement plan that gives employees the chance to receive interest in employer stock. Upon retirement, employees can either receive cash or shares, which are then sold back to the company. To qualify for an ESOP, a company should be closely held, have EBITDA in excess of $3 million, have at least 30 employees and have annual payroll of $1 million or more.
Why would an owner consider an ESOP?
With an ESOP, the owner still runs and manages the business the same; the only change is that the shares are owned by a trust for the benefit of employees. Forming an ESOP is a good way to protect the jobs of employees, which may be lost in a sale. Additionally, any S corporation that is 100 percent ESOP-owned does not pay federal income tax. Employee-owned companies also experience lower turnover, less absenteeism and higher productivity, while employees report better mental health and workers receive higher pay and better benefits.
The drawback is that they’re complicated to construct and require knowledgeable professionals to close. But once in place and acquisition debt is paid off, employees tend to not only be more productive, but they are more careful with expenses because they are invested to improve the company’s performance for their own benefit. However, ESOPs are not for everyone. It’s math, not magic. It can work for a lot of companies, but owners need to spend time with their banker learning about ESOPs before moving forward.
How can my banker help with forming an ESOP?
Your Huntington banker can help coordinate resources, such as a financial advisor, who will conduct a feasibility study and help the owner understand tax benefits and accounting changes. They will also coordinate with an ESOP lawyer, who will write an ESOP plan consistent with ERISA rules. The lawyer and financial advisor will also help the owner choose a trustee for the trust that will own the company’s stock and maintain fiduciary responsibility for the benefit of the employees.
What is the transaction process?
The trustee will hire an evaluation company to determine the full and fair price for the company’s stock. The owner and the trustee, with their respective financial advisors, will then negotiate and ultimately settle on a purchase price, which your bank will help finance. The trust borrows money to buy a portion of the company’s stock, and then borrows the remainder from the owner to buy the rest.
The bank’s loan is the senior debt, under which the seller notes—the portion the owner provides—are subordinate. As the company generates money during the normal course of business, it pays down the senior debt to the bank. Then the company asks the bank to refinance a portion of the seller notes, pays off that loan, then repeats the cycle until the company pays off all of the seller notes. Owners typically continue to work in the business until the seller notes are paid off, which takes about five years, but could be faster because employees tend to become more productive once they have a stake in the company. Via specific tax elections, the owner may defer the capital gains of the sale. And the business, which is now fully owned by the ESOP and held in trust by the trustee, doesn’t pay any income tax, even though it continues generating profits. That could mean, based just on the effective tax rate, that the company is now earning some 30 percent more than it had just by virtue of being an ESOP.
Our Huntington team has helped many businesses navigate this complex business solution.
To explore whether an ESOP is right for your company, contact Kevin Ward, senior vice president, Huntington, at Kevin.Ward@huntington.com or (513) 762-1812.