Exit Option Three: Transfer to Employees via ESOP

Many business owners will utilize an ESOP (Employee Stock Option Plan) as part of their exit strategy.  It provides many of the same advantages as selling to Key Employees (see previous blog) but without many of the disadvantages. Those advantages include:

  • Puts the company in the hands of a known entity
  • Perpetuates the company’s mission or culture
  • Keeps the company in the community
  • Allows the owner to remain involved in the company and
  • Achieves financial security

First, an ESOP is a qualified retirement plan (typically a profit-sharing plan), in which all employees participate, investing primarily in the stock of the sponsoring employer.

ESOPs appeal to owners who wish to transfer their companies to known entities, perpetuate their companies’ mission or culture and keep their companies in their communities. The owner who uses an ESOP to transfer to employees may enjoy three benefits that the owner in a standard transfer to key employees may not:

  1. Beneficial tax treatment: Using an ESOP, an owner may be able to defer or avoid tax on the sale of the stock to the ESOP. Even more importantly, the company can pay for the owner’s stock with pre-tax dollars.
  2. More cash sooner: The owner may be able to leave the closing table with all of the cash necessary for a financially secure retirement due to more favorable tax treatment, and the greater possibility of at least some outside financing.
  3. Motivated work force. Because all employees participate indirectly in the benefit of ownership as ESOP participants, performance may improve. Studies, including one by Douglas Kruse and Joseph Blasi of Rutgers University (Jeff: find citation), indicate that this can be the case.

Of course, not all aspects of the ESOP exit route benefit the owner. Disadvantages include:

  1. Owners must take into account the cost and complexity of setting up and maintaining an ESOP
  2. At closing, owners may receive more cash than they would in other key employee transfers, but perhaps not as much as they would have, had they sold to a strategic buyer
  3. In securing the ESOP loan, an owner’s assets may be tied to the company as collateral
  4. In many cases, key employees may not benefit as significantly as the owner might have anticipated nor as much as the employees may demand to stay on and run the company after the owner leaves

Of course, good planning—well in advance of the owner’s exit—may substantially minimize or eliminate these disadvantages.

Our blog series on Exit Strategies will continue with the option of a sale to co-owner.