Understanding ESOP Succession Planning Benefits vs. a Conventional Sale/Exit Strategy
By Doug Janowski, Managing Director, Lazear Capital Partners
Employee ownership has been a rapidly growing force in the AEC industry for decades, yet many owners are still learning how Employee Stock Ownership Plan (or ESOP) succession plans offer unique advantages with which conventional exit strategies simply cannot compete in many cases.
Of course, ESOPs are not always the right solution for every owner or every company transition.
A pure exit strategy such as selling to a strategic competitor or to a private equity buyer can have advantages, but both paths need to be explored based upon the financial and personal goals of the owners.
The flexibility of the ESOP structure often provides a comprehensive strategy which can advance the interests of everyone involved in the organization, including owners, management, employees, and customers.
This article breaks down where to start when considering whether an ESOP succession plan might be the right approach for you and your business.
Business owners in the AEC industry receive unsolicited offers to buy their business on a regular basis – often receiving up to 10 or more “blind” offers per year.
This reality forces them to continually wrestle with fundamental questions such as: “Am I really ready to end this leg of my journey with my team? At what cost? And what will I do next?”
Owners recognize a traditional sale of their business signifies the end of their time at the company they started and built over many years.
In most cases, the ideal retirement time frame is still five to ten years away and they have plans for the business, along with concerns for the success and well-being of their team who helped bring their vision to life.
To add to the complexity of this choice, there is a pressing need to separate personal financial success and family/wealth/estate planning from the business’ finances. So, how can ESOPs provide a succession plan that connects these fundamental goals?
The chart below breaks down the high-level differences of ESOP and non-ESOP transactions.
ESOP Succession Planning
Conventional Exit Strategy
|The selling owner can stay involved until theywant to step away and management cancontinue to build upon their vision.
|Sellers are typically not involved after a shorttransition period.
|Similar to a “financial buyer,” ESOPs pay the full fair market value for the company, which is determined by the ESOP trustee’s valuation advisor based upon current market conditions and similar companies.
|Private equity investors or strategic buyers base the purchase price on their perception of the value of the company; the nature of the business; and their targets for returns on their investment.
Employee Involvement in Sale
|Employees, through their ESOP retirement plan purchase the shares from the owner over time; without using any of their own money or taking any personal risk.
|ESOPs do not require equity capital in the transaction. Financing is supported by a bank (many of which have ESOP lending teams) and the seller.
|Third-party buyers require equity and bank financing to purchase the company.
Tax on Sale
|The Employer Retirement Income Security Act (ERISA) of 1974 created the opportunity for owners to receive proceeds from the sale of the business tax-free, eliminating the need to pay any Capital Gains taxes on the proceeds. This means owners in Texas will receive 20% more of the proceeds after-tax by electing a 1042 exchange. In other states, the tax savings will be even higher.
|The sale is taxed as a capital gain and any ordinary income taxes when paid. Some tax planning can help mitigate taxes, but not defer or eliminate them entirely.
Go‑Forward Income Tax
|Under ESOP/S-Corp ownership, the company will not pay any federal or state income taxes (in most states) going forward.
|The company will operate under the standard IRS tax structure and requirements.
|ESOPs are a proven tool for attracting and retaining employees, which does not require employees to take any monetary or personal risk.
|Benefit options for employees are at the discretion of the buyer and are likely limited to traditionally defined contribution plans, as well as achieving the targeted return on investment.
|The legacy of the company (often a second or third generation business) is kept intact for the next generation of management, employees, and customers.
|No certainty of legacy.
ESOPs can be a tremendous succession strategy; delivering value to everyone involved in the organization and surrounding community. While no one can say whether an ESOP structure is the right solution for every owner or company, it is a universal buyer for almost any successful business. Therefore, it is always worth taking the time to understand if this structure might be the best option for meeting the owner, management and company’s objectives.
About the Author
Lazear Capital Partners is a leading middle-market investment bank specializing in Employee Stock Ownership Plans (ESOPs), Mergers and Acquisitions, and Capital Formation.