ESOPs: Not just an exit strategy anymore

Not many business owners are aware of what an employee stock ownership plan can do for their corporation.

For years, ESOPs have been used as a way to create incentive among employees, which has been shown to increase a company’s profitability.

And ESOPs have garnered attention as an exit strategy — but they can be much more than that.

ESOPs can also be used in three different ways as a corporate finance tool, said Ron Lint, CEO of ATI Capital Group of Colorado LLC.

The first way is to buy depreciable capital goods, and then write-off the goods twice — with Uncle Sam’s approval.

“You can’t do that with anything else without going to jail,” Lint said.

After establishing an ESOP, a corporation in need of $5 million in equipment, may obtain a loan from a financial institution, which is more likely to lend because an ESOP has increased cash flow. Then the corporation lends the money to the ESOP, which in return purchases $5 million in shares from the corporation. Then the corporation buys the capital goods, and depreciates them over the allowable period of time on its taxes.

And the entire loan for the capital goods — principle and interest — is tax deductible.

The second way to use an ESOP for corporate finance is to buy another company.

“In this day and age when so many companies are in trouble — if your company is in an acquisition mode, this is the only way to buy a company with pre-tax dollars,” Lint said.

And the third corporate finance use of an ESOP is to pay off existing debt. Lint recently helped a corporation through this procedure, saving the company about $6.8 million (based on a 40 percent marginal tax rate) on a $17 million loan, because the principal and interest on the new loan are tax deductible.

When ESOPs were first created under ERISA, The Employees Retirement Income Security Act of 1974, they garnered attention for their tax incentives.

“The main purpose of the legislation was to encourage employee ownership of a company,” said Jim Vonachen, tax partner with Clifton and Gunderson LLP. “But with the credit markets drying up, banks are reluctant to loan money to buy medium or small businesses. Buyers can’t get financed, but sellers still want to exit. So people are looking to ESOPs to split up the transaction.”

As long as the seller reinvests the money from the sale of the stock in the stock market, then he or she does not have to pay capital gains tax on the sale of the company’s stock. Currently, federal capital gains tax is 15 percent, and Colorado’s is 5 percent — a savings of 20 percent.

And the buyer gets tax-deductible financing because the ESOP is an operating deduction for the company.

“The market today doesn’t value companies the way it used to,” said Loren Lancaster, managing director of the Electronics and Semiconductor Group of Core Capital Group. “So the (after-tax dollars) gap between a free market valuation and an ESOP valuation has narrowed. We’re not in the heady days of 1999 or 2006 anymore.”

But, of course, an ESOP is not a panacea. There are a few caveats. If a company is likely to obtain a high valuation, or conversely, if the company is likely to fail or have cash flow problems, then an ESOP is not a wise idea, Lancaster said.

Or if an entrepreneur doesn’t want to be accountable to others and doesn’t care for the philosophy of an ESOP, then it wouldn’t work for them, Vonachen said.

ESOPs, after all, are designed to encourage employee input and leadership.

And the annual reporting and valuations necessary to maintain an ESOP can be costly, so this also should be considered.

The ESOP Association estimates the number of ESOPs in the United States at 11,500.

And there are only 35 known ESOPs in Colorado. But that is likely to change.

“ESOPs are poised to explode,” said Brandt Brereton, a Silicon Valley investment banker who specializes in ESOP transactions and services.

“The confluence of permanently lower merger and acquisitions multiples, rising tax rates and a three-fold increase in the number of Baby Boomer-aged sellers about to roll through the system is going to drive significantly more tax-free ESOP sales transactions over the next decade — especially compared to taxable M & A transactions.”

Because many banks are undercapitalized, and the current administration wants them to double their capital reserves, “they will never be in a position to lend as aggressively as they did in the last 15 years,” Brereton said. This will, in effect, cap M & A multiples at four to five times EBITDA (earnings before interest, taxes, depreciation and amortization), which will only make ESOPs more attractive to sellers.

Many business owners are ready to start the transition to retirement. Especially if they realize it cannot be accomplished overnight.

“Selling a company is a process — not an event,” Lint said.

In this market, “selling as an event is a fairy tale. Generally, the owner sticks around for three to four years while this process is going on,” Lint said.

And, compared to selling a company, which can take up to two years, a typical ESOP can be completed in 90 days. Many of Lint’s clients sell the stock in their company to the ESOP in three stages, gradually transitioning the business and turning over more control to their managers. Although 100 percent of the shares can be sold at once, the minimum needed to form an ESOP is 30 percent.

“ESOPs are a very flexible instrument,” Lancaster said. “And it’s a way for the owner to transition ownership. More often than not, the owner is trustee of the ESOP and he or she still makes many of the strategic decisions.”

And banks like ESOPs because they normally have more collateral backing the loan — shares of the company in the ESOP and collateral from the company itself, such as equipment and receivables, Lancaster said.

Corporations with employee stock ownership plans tend to be more successful than other businesses, making the loan less risky for the bank or financial institution. And because principal and interest payments are tax-deductible, businesses have better cash flow.

And sellers are usually quite concerned about their company and employees.

“They don’t want to sacrifice everything — their product or service, the legacy of the business — and get out. And you can’t measure the value of that in dollars. They’ve empowered their employees to be successful, invested a lot of their lives in them, and think of them as family. They don’t want them to be fired (by a new owner) or have production sent overseas,” Lancaster said. “So an ESOP allows you to put the company into the hands of the people you care for, who will protect your company.”

In Colorado, during the last six to eight months, Vonachen has noticed a trend toward using ESOPs to buy, sell or transfer a business. “Under the right set of circumstances — it works beautifully,” Vonachen said.

Brereton anticipates that economic and capital conditions will drive the trend for about 15 years.

“ESOPs are back in vogue,” Brereton said.

And there’s nothing except room for growth in the state.

“Texas and California have a huge number of ESOPs,” Lint said. “In Colorado, we’re an under-ESOP-ed state.”

What is an ESOP?

An employee stock ownership plan is a qualified plan under ERISA — the Employees Retirement Income Security Act of 1974. An ESOP is a defined contribution, tax-qualified plan that has two distinguishing features. 1. An ESOP is allowed to invest exclusively in the stock of its sponsoring company. 2. An ESOP can borrow money.

What can it do?

A sponsoring corporation can contribute cash or stock to an ESOP on a tax-deductible basis, thus increasing cash flow. Owners of privately held corporations can sell all or part of their stock to an ESOP for full fair market value, and can avoid capital gains tax by immediately reinvesting the money in stocks or bonds.

Source: Ron J. Lint, ATI Capital Group of Colorado LLC.

Benefits of an ESOP for the corporation

Corporation obtains 100 percent tax-deductibility of principal and interest on loan payments on an ESOP.

Corporation can fully deduct dividends paid to the ESOP and its participants.

Corporation has increased cash flow due to the deductibility of principal on an ESOP loan.

Collateral for an ESOP loan is created outside the corporation.

The selling shareholder’s retirement is funded outside the corporation, relieving the company from the burden of funding retirement benefits.

Corporation can refinance existing debt on a tax-deductible basis.

Corporation can purchase capital goods using pre-tax dollars.

Corporation can merge with or acquire another corporation using pre-tax dollars.

Source: Ron J. Lint, ATI Capital Group of Colorado LLC.

Is your corporation a candidate for an ESOP?

The company is a C Corp. or an S Corp.

And the corporation has unused debt capacity; is profitable and has sufficient cash flow for additional ESOP acquisition debt; pays taxes at or near the top marginal bracket; has payroll of at least $1 million, excluding seller; produces at least $7 million in annual revenue; the majority shareholder is interested in sharing equity ownership with employees, in order to attract, retain and reward productive employees; and the corporation has a strong secondary management capable of taking over the company.

Source: Ron J. Lint, ATI Capital Group of Colorado LLC.

Benefits for the shareholder (seller of the company)

If structured properly, the sale of stock to an employee stock ownership program is tax-deferred, under Section 1042 of the Internal Revenue Code.

Seller obtains top dollar and controlling interest value on the sale of stock to an ESOP.

Shareholder can sell stock and remain in control of the company.

Seller obtains additional annual income due to investing pre-tax dollars.

Seller diversifies investments and also obtains liquidity and flexibility for estate planning.

Seller has control over the sale of his or her stock, and can transfer management responsibilities over time.

Source: Ron J. Lint, ATI Capital Group of Colorado LLC.

  • There are approximately 11,500 ESOPs in place in the U.S., covering 10 million employees (10 percent of the private sector workforce).
  • The growth of ESOP formation has been influenced by federal legislation. While the rapid increase in new ESOPs in the late 1980s subsided after Congress removed certain tax incentives in 1989, the overall number has remained steady with new plans replacing terminated ESOPs.
  • Approximately 4,000 ESOP companies are majority-owned by the ESOP.
  • Approximately 2,500 are 100 percent owned by the ESOP.
  • At least 75 percent of ESOP companies are or were leveraged, meaning they used borrowed funds to acquire the employer securities held by the ESOP trustee.

Source: The ESOP Association