Expertise Beyond the Numbers

Why ESOPs are a Common Alternative to Third-Party Sale for Engineering Services Firms

As previously noted, we expect M&A activity in the engineering services space will remain strong as long as the current economic expansion persists, and capital remains easily accessible.

The consolidation trend will continue as talent and capability gaps are going to continue to drive larger firms to acquire smaller firms. Consolidation is creating more one-stop-shop service providers as these larger firms strive to enter new geographies and bolster their portfolio of offerings.

Although the M&A market is strong, is selling to another company the right move for your firm?  When it comes to choosing a succession strategy, two of the most popular options for business owners are an outright sale to a 3rd party or selling to an Employee Stock Ownership Plan (ESOP). Below we compare some of the key characteristics of these two liquidity options.

Is There an Interested Buyer?

A sale to another company hinges on your firm’s attractiveness to the buyer community as an acquisition target.  Differentiation is key, as we have shared in a prior post, and there are key quantitative and qualitative KPIs executives need to monitor to position their company for sale. A few of the value drivers include the area/industry of expertise, scale (size), appealing KPIs, and strong financial performance.

If a readily available buyer does not exist, and ESOP is another option for business owners to consider.  ESOPs are an alternative to a third-party sale, and often are attractive options to create liquidity for the business that they’ve created.  An ESOP allows the business owner to sell it to all of his employees by creating a buyer via a trust that exists for the benefit of the employees.

In using an ESOP, sellers get to “create” a buyer and generate liquidity in an transaction, as the companies often borrow money from a lender to finance a portion of the sale of stock to the ESOP. Additionally, some sellers want more than just money; they also desire to pass their company on to the employees they care about to protect and promote them as well as the legacy they have created through their years of toil and leadership.

Level & Speed of Liquidity

An outright sale to a third-party typically offers the highest level of liquidity delivered immediately at closing or within a short period of time after the transaction (if there is an earnout as part of the structure). An ESOP transaction is a gradual transition strategy that generally is better suited for owners who are looking to transition out of the business gradually over time.

Selling to an ESOP involves adding debt to the balance sheet that must be serviced at a certain level and with the certainty of repayment.  Further, bank lending levels limit the amount of debt that an ESOP can have on the balance sheet, which forces selling shareholders to either retain partial ownership or take sellers’ note for any non-bankable portion of the purchase price.

Cultural Fit

In an M&A transaction with a third-party, both buyers and sellers spend a significant amount of time checking and confirming a cultural fit between the firms.  In addition to the myriad other areas of due diligence, the examination of cultural fit is often the most critical with the highest probability to either get both sides excited or sink a deal.

An ESOP is an interesting cultural solution from an ownership standpoint as it allows a selling shareholder to sell the business to its own employees.  ESOPs allow business owners who value their existing corporate culture the ability to keep that culture in place. The ESOP transactions allow the shareholders to share the stock and transfer the control of their firms gradually, so it’s not done all at once as it would be if it was in a third-party transaction.

Further, owners can slowly decrease their role in the company and they can remain active in the business years after selling to an ESOP. The continuation of leadership and the management team is usually helpful in the transition to preserve the continuity of the company’s culture.

Simplicity of the Transaction

The process leading up to an outright sale in an M&A transaction is a complicated and time-consuming process.  However, the actual sale to the buyer is intellectually quite straightforward, consisting of the exchange of some value (cash, stock, note) for the equity or assets of a company.

An ESOP is a nuanced transaction that requires coordination with multiple service providers and is not as straightforward as selling to a third-party buyer, collecting a check, and heading to the beach to live out retirement. The ESOP that is created is a trust for the benefit of the employees that will exist in perpetuity and requires annual valuations, a trustee to oversee the ESOP, and additional maintenance of the trust. For businesses with an enterprise value of less than $5 million and fewer than 30 employees, an ESOP may not be worth the effort and expense of setting up and administering.

Additional benefits of ESOPs:

Many business owners find value in these additional benefits of ESOPs as well:

  • Employee Recruiting and Retention: Due to the service-based nature of the industry, employees are the most valuable assets of the firm. ESOPs create a competitive edge to attract and retain top talent.
  • Tax Advantages: The ESOP structure can significantly reduce or even eliminate a company’s corporate tax burden. Annual contributions to the ESOP are tax deductible for all companies, but the most significant tax benefits are accomplished when an ESOP owns 100% of the common stock of an S corporation. Firms that are structured as 100% S corporation ESOPs are tax-free entities that can reinvest the tax savings in the business’ growth.
  • Flexible Shareholder Liquidity: Engineering firms often have multiple partners who have different retirement and liquidity goals. ESOPs are often the only viable option for engineering firm owners seeking partial liquidity since most strategic buyers will only want to acquire a controlling interest in the firm.

ESOPs are not for Every Seller

An ESOP doesn’t make sense for every industry or for every engineering firm. ESOPs work best for operating businesses such as manufacturers, distributors, government contractors, professional services providers like engineering firms; essentially companies that generate relatively consistent earnings, not startups working to achieve stable financial footing or organizations in highly volatile industries like oil and gas.

Due to the nuances involved with either selling to an ESOP or selling to a third-party buyer, it is extremely important to carefully consider the pros and cons of each.  Prudent business owners will seek out qualified advisors to help them evaluate, choose and navigate the right exit option for them.

For more information about M&A and ESOPs in the engineering services industry, please contact us.