Figuring out a solid exit strategy can feel like a daunting challenge for business owners. Finding the right buyer isn’t easy. Some owners may choose to sell to a third party or wind down the business and shutter its doors entirely. But this can be a difficult decision; it could leave your employees out of work and ends the legacy of your business.
If you want to keep your business locally rooted and your employees meaningfully employed, there’s another option: an Employee Stock Ownership Plan, or ESOP. It’s essentially a way to sell your business to your employees. In an ESOP sale, all employees gain partial ownership of the company. The longer they remain employed with the company, the more stock they stand to receive.
According to the National Center for Employee Ownership, as of 2016, the most recent year for which data is available, there were 6,624 ESOPs in the United States, holding total assets of more than $1.4 trillion. These range from small private companies to large public companies, and just about every type of company in between. Depending on the size of your company, timeline and long-term business goals, this exit strategy could be a viable option. In deciding the best approach for your business, take these factors into consideration.
Weigh the tax benefits
While many exit strategies may seem appealing, ESOPs are worth exploring because of the tax advantages. On a net after tax basis, an ESOP sale often results in the seller receiving more than other third-party sales.
To encourage more business owners to sell to their employees, the government incentivizes these sales. As the seller, you can defer paying taxes on the sale—possibly forever. This is one of the biggest pros of an ESOP sale.
Business owners consider selling to an ESOP for the tax benefits while rewarding employees and keeping the culture of the company intact. Many ESOP companies pay little or no income tax due to their ownership by a Qualified Retirement Plan.
Shape the legacy of your business
You’ve worked hard to grow your company. Even if it’s reached the time in the lifecycle of your business to transition out, you still want your business to thrive. An ESOP could be a viable exit strategy that fosters future business growth.
On average, ESOP companies grow 2% to 3% faster than would have been expected without an ESOP, according to the National Center for Employee Ownership. They also have lower turnover and 2.5% higher productivity.
These results are not automatic, however. For the most successful ESOP companies, NCEO sites one important factor: ownership culture. This means companies are more likely to grow post-ESOP if they are transparent with employees about financial information and involve them in making decisions.
Plan for the appropriate amount of time
If you’re looking to quickly exit your business and move on, this might not be the right exit strategy. An owner who is looking to cash out completely in a sale may not be right for an ESOP. It usually takes a few years for the seller to be fully paid out.
Like all third-party sales, there is some complexity involved in an ESOP, both initially and ongoing. You’ll need some time to prepare your business for the transition, which can take as little as six months, but more typically takes up to 12 months of preparation.
You may hire an ESOP lawyer or ESOP-knowledgeable investment bank to guide you through the process. While this will increase the cost somewhat, it usually results in a more tailored thoughtful structure that is worth the cost.
Consider the size of your business
ESOP sales do require upfront and maintenance costs. These costs will vary depending on the size of your business and other factors, but most ESOPs will pay between 2.5% and 5% of their sale price. Smaller deals will sometimes pay a higher percentage due to more fixed dollar costs.
Very small businesses and those with very few employees are harder to make an ESOP the right fit. Due to the upfront and maintenance costs, some people suggest 25 employees and a minimum of $1,000,000 in pretax income; however, it is still possible for smaller businesses to undergo an ESOP sale. It’s best to speak with an ESOP Professional to discuss the feasibility of an ESOP for your business.
Lastly, only certain business entities are permitted to undergo these sales. Only S-Corps and C-Corp ESOPs are allowed. You may have to convert or elect a different status for your business before moving forward.