You’ve likely heard about employee stock ownership plans (ESOPs) but are more familiar with other third-party options like selling to a larger competitor or private equity. But each year, an increasing number of construction and contractor owners choose an ESOP for their succession plan.
What is it you need to know about ESOPs? Let’s take a high-level look at this increasingly popular succession strategy because there’s one question that’s not going away: “What are you going to do with your business?”
The ESOP Basics
What is an ESOP?
An ESOP is a qualified retirement plan created by Congress in the 1970s. The Department of Labor (DOL) has oversight authority on ESOPs.
Who do ESOPs benefit?
Congress offers various ESOP incentives and benefits for the owner(s), employees and the company itself.
Who owns the company in an ESOP?
An ESOP trust is created and becomes the sole owner of the company in a 100% ESOP sale. Employees are commonly referred to as “employee owners” but technically they own the right to a beneficial interest (i.e., ESOP shares.)
ESOP Information for Owners and Companies
Why do some owners choose an ESOP?
No two companies or owners are the same. However, the following list of “Owner Reasons for an ESOP” originates from my experience representing approximately 200 business owners in new ESOP transactions:
• Receiving full and fair value for the business
• Maintaining continuity of operations and leadership positions, (“operational control”) for a flexible time-period
• Reward employees
• Preserve culture and legacy
• Ability for the business to operate income tax-free (federal and most states) after close of the ESOP transaction
• Protect employees and communities against sudden changes that can result from other forms of sale
• Either no heirs to take over the business or the owner prefers to have heirs run (not own) the business with checks and balances in place
• Create an owner mindset among employees that can help productivity, retention and recruitment
What’s the valuation methodology for an ESOP?
ESOPs are valued using a “fair market value” valuation methodology. For construction firms, this generally means analyzing the future cash flows (or projections of financial performance), including what other similar businesses have sold for as well as what public companies in that industry are trading for in the market. In short, the buyer in an ESOP is a financial buyer most interested in the future cash flows of the business.
What do investment banks do for owners in an ESOP?
Among their duties, investment banks (IBs) educate owners on ESOPs, represent owners in the ESOP transaction and advocate for value on the owner’s behalf by negotiating the terms of the ESOP with the buy-side, which consists of a trustee and valuation firm.
In addition to analyzing potential financing structures, tax ramifications and the ability to effectively design the ESOP retirement plan itself, IBs produce a feasibility analysis (FA) customizing the ESOP alternative to the company. Through analyzing future cash flows, the FA begins to answer the question, “What might my company be worth in an ESOP?”
IBs also run the full banking process to source capital for the deal and coordinate the transaction.
Following the feasibility analysis, owners wanting to move forward with an ESOP should expect the closing process to take how long?
There are various factors to consider but four to five months is a common time-period to complete the close of an ESOP transaction.
How can owners maintain continuity of operations and leadership, aka “operational control”?
In a 100% ESOP sale, owners sell their stock but generally maintain their current position as an officer and leader of the business. It’s also common for an owner to maintain a seat on the board of directors with more formal or “stepped-up” corporate governance.
Owners can remain in the day-to-day operations of the business, be on the board or both. In short, owners enjoy some flexibility and control in the decision and timeline to phase out of the business and the ability to change their role over a period of time.
How do owners receive their sale proceeds in an ESOP?
It varies, but in general three main ways:
(1) Up-front cash at close, typically 20–40% of purchase price and with no personal guarantee
(2) Principal payments from a promissory note (“seller note”) payable to the selling shareholder from the company and dependent on future cash flows, and
(3) Cash interest and interest replacement warrants (like a stock option) as an interest related return on the seller note. These warrants serve as an owner’s “second bite at the apple,” an all for owner participation in the upside of the company for a handful of years post-close of the ESOP.
What’s the main tax advantage of ESOPs for selling shareholders?
Section 1042 of the internal revenue code enables selling shareholders to defer and ultimately eliminate capital gains tax on the sale of their shares to an ESOP. This incentive was created by Congress to incentive business owners to do an ESOP.
What’s the tax advantage available to a company doing an ESOP?
A 100% ESOP-owned company that is an S-Corp (please define S-Corp here) post-close is exempt from federal and most state income tax. This extra cash flow can allow for an accelerated repayment of the seller note and significant value creation for employees.
Employees and ESOP Shares
Does the ESOP retirement benefit for employees replace the existing 401(k) plan for a company doing an ESOP?
It’s up to the owner(s), but most companies keep the existing 401(k) plan and layer the ESOP on top as an additional retirement benefit.
Do employees contribute their own money in an ESOP?
No. The company provides the ESOP shares as an additional benefit to employees at no cost to the employees.
How do employees earn shares?
A vesting schedule for years of service post-close is created for employees. A common vesting schedule is a sliding scale over the first six post close years (0%, 20%, 40%, 60%, 80%, 100%.)
Do all employees receive the same number of shares?
No. Typically shares are earned based on relative compensation. For example, an employee making $100,000 annually would earn twice the ESOP shares as an employee earning $50,000.
Can years of service before the ESOP be considered in the ESOP compensation formula?
Though less common, owners have the option of creating a formula that considers relative pay while also factoring in years of service.
How are employees paid out for vested shares in an ESOP?
It depends on how they leave. If a vested employee leaves via death, disability or retirement, the company typically pays out an employee for the value of their vested shares over a one-to-six-year period.
By contrast, if an employee is fired or leaves for a competitor, the company typically pays? (was missing a word here, please confirm) them out over a five- to 10-year period, which incentivizes long-term employee retention.
Like pre-tax, “traditional” 401(k) money, ESOP shares are pre-tax dollars subject to retirement compensation rules and typically need to be rolled into an IRA by the employee upon receipt. Consult your tax or investment advisor for further assistance.
Management Incentives
The management team will drive future earnings and the value of the company post-close. In an ESOP, it’s important to align selling-owners and management on the value of performing post-close.
Non-ownership management can participate in the ESOP. However, a separate cash bonus, equity-like, incentive plan is normally put in place for key executives.
These typically come in the form of stock appreciation rights (SARs), which allow management to receive compensation based on the appreciation or increase in the value of the company stock.
A SARs plan helps create alignment among employees, management and ownership. For example, if the company performs better, the price per share will be better for the ESOP shares earned by employees.
In addition, a well-performing company also means management likely hits its post-close annual targets to earn the cash bonus (SARs.)
Meanwhile, both employees and the management team also want some of the extra cash flow from solid company performance to reduce the seller note and pay off the owner as quickly as possible, reducing the debt load on the company.
This alignment of interests of all parties within an ESOP company gives rise to the popular metaphor of “rowing the boat in the same direction.”
Finally, SARs also allows management to participate in equity-like incentives without the risks associated with equity ownership.
Conclusion
In summary, for most business owners, ESOPs are a less understood but potentially powerful tool and transition plan.
To make informed decisions, business owners must gather the relevant information necessary to form an educated opinion on the best succession plan.
So, I encourage you to talk with an ESOP professional/investment banker who is active in the ESOP transaction space. Most IB firms do only traditional third-party sales. You need someone with ESOP experience and references to share.
An ESOP may or may not be right for you and your company. But until you have conversations with the experts from the ESOP industry, you just don’t know.
Stephen Arnold is a managing director at Lazear Capital—an Ohio-based investment bank with a nationwide team and presence in the ESOP industry. He educates owners across the country about ESOPs including advantages and disadvantages and how they compare to more traditional third-party sales. Lazear Capital is one of only a handful of firms that represents owners in both ESOP and traditional third-party transactions. If you have a question, Stephen can be reached at sa@lazearcapital.com.
