ESOPs as a Liquidity Option
October 16, 2017
We work with business owners who are in various stages of exit strategy planning. At the earliest stage, shareholders should consider and understand all of the different liquidity strategies available to them. Through our discussions, we help to identify and explain all of the options that are available to transition the ownership of a privately held company, including a sale of the company to a strategic buyer or private equity firm, management buyout, and a sale to the company’s employees through an employee stock ownership plan (ESOP). Of all the liquidity options, ESOPs tend to be the most perplexing to business owners.
ESOPs are increasing in popularity due to their flexible transaction structures, significant potential tax advantages, and favorable current credit markets. However, an ESOP is not a one-size-fits-all solution. Each ESOP transaction is uniquely structured and may be a more advantageous option for some companies than others. Businesses in the following situations often find an ESOP to be a viable liquidity option.
Engaged Management Team Without Means to Purchase the Company
Owners may prefer to sell a company to its management team – the people who care the most about the success of the business and have helped to build it. However, the management team may lack the funds to buyout the owner. An ESOP can be used to get the management team substantial equity over time without them having to find money to finance the buyout.
Not all shareholders have the same long-term goals, making it difficult to structure exit-strategies for multiple owners. When certain shareholders want to exit the business and others do not, an ESOP may be a good solution to buy out certain shareholders, while allowing other shareholders to maintain control of the Company.
With proper transaction planning, a family-owned business can utilize an ESOP to gain liquidity and diversify their personal assets in a tax advantaged manner, while retaining family control of the company for future generations.
Certified Minority or Women Owned Business
Minority or women owned businesses often have limited liquidity options, as potential buyers may not qualify to take over the company’s set-aside contracts. In a traditional M&A transaction, a buyer would apply a discount to the value of the minority or women owned business; however, with an ESOP, owners can sell a non-controlling interest and maintain the company’s set-aside status.
IRS Code Section 1042 provides beneficial tax treatment on shareholder gains when selling stock to an ESOP. If properly structured, eligible sellers of C Corporation stock to an ESOP can defer and potentially eliminate their capital gains tax liability on the sale of stock. Proper ESOP planning and discussions with a tax professional are a must.
For government contractors, contributions to the ESOP are eligible costs under the FAR and thus can be passed through as part of a company’s indirect rates on certain cost-plus type contracts.
We recommend you work closely with an ESOP planning expert to determine if an ESOP is a feasible option for your business. Contact us to discuss whether or not an ESOP is a liquidity option for your business.