Fast Facts on ESOPs
The first half of 2018 has seen an increase in middle market M&A, particularly with respect to privately held businesses. Many of these business owners are directly interested in employee ownership as an alternative alongside traditional M&A strategies such as a strategic or private equity buyer. Interest in ESOPs seems to be fueled by three key drivers:
- The new tax law mitigated the uncertainty about what corporate tax policy would be. It is difficult to discern and compare alternatives without visibility to tax implications. ESOP tax benefits remained unaltered
- The tax law did not change personal taxes as dramatically as it altered corporate taxes. ESOPs are an interesting consideration for business owners who see value in the opportunity to permanently defer capital gains taxes
- Labor markets are tightening. How does a company successfully attract and retain talent? Employee ownership impacts employee engagement and employee productivity, helping drive long term results
Notwithstanding increased interest in ESOPs, professionals and business owners alike remain confused on many levels with respect to employee ownership. Who better to set the record straight with some fast facts than Mary Josephs? Josephs has worked in and around ESOPs for over 30 years. Mary founded Verit Advisors in 2009 in Chicago and has over three decades of experience in corporate finance for private businesses. Josephs and her team are considered to be the foremost experts in ESOP transactions and middle market strategic alternatives.
Q: What exactly is an ESOP?
Mary: ESOP stands for Employee Stock Ownership Plan. An ESOP is an innovative liquidity tool that provides flexibility for shareholders, tax advantages for the company and business owners as well as an opportunity for employees to grow retirement assets. Employees participate in the economic growth of their employer via company stock held in their retirement accounts.
Q: How many ESOPs are in the U.S.?
Mary: Currently there are almost 7,000 ESOP plans in the U.S. The NCEO (National Center for Employee Ownership) estimates that approximately 28 million employees participate in employee ownership plans. Overall, employees now control about 8% of corporate equity.
Q: How does an ESOP get set up?
Mary: Companies set up a retirement plan trust (think of a 401(k) plan) for employees. Annually, the employer will contribute or allocate company stock directly to the plan. Contributions to the plan are tax-deductible. Employees pay no tax on the contributions. They will pay ordinary income when they retire and withdraw the value from their retirement account, just like a 401(k). I wrote a blog about WinCo Foods where 130 employees have a combined ESOP retirement account of an astounding $100 million. This figure is continuing to grow rapidly, such that in a few years the average wealth of these employees could easily exceed $1 million. That is pretty impressive.
Q: How do the founding shareholders achieve liquidity?
Mary: Great question. What is the source of funds? With a PE sale, the PE firm provides equity, lenders add senior and junior capital, and the business owner generally has an earnout. With a strategic sale, the buyer uses their stock and/or debt capacity and generally an earnout. With an ESOP, the employees don’t literally buy the company. They don’t have the resources. The company borrows money from lenders and purchases shares from selling shareholders.
Q: Why would a company become employee owned?
Mary: There are several reasons why an owner(s) might transition to an ESOP.
- Diversification: ESOPs are an effective liquidity strategy for founders and subsequent generation owners who worry that much of their wealth is tied up in their privately held business. ESOPs enable business owners to achieve some liquidity without an outright sale of the business to a private equity sponsor or a strategic buyer
- Continued Equity Interest: Many privately held business owners believe in and want to continue to participate in the equity growth of their business. ESOPs are flexible and enable owners who would like to sell all or part of their business, to retain the opportunity to participate in future equity appreciation
- Culture: ESOPs are most effective in companies where the established or desired culture cares about the employees. In fact, decades of research on ESOP companies confirms this. In order for companies to enjoy the improved growth and profitability metrics associated with ESOP companies vis a vis their peers, the company needs to have (1) a meaningful percentage of employee ownership and (2) a culture that reinforces the importance of employees
- Avoiding an M&A process: The standard M&A process is both time consuming and uncertain. Management worries about leaks of confidentiality (process, formulas, clients, talent, etc.) that it doesn’t want shared with the public. ESOPs generally have the utmost confidentiality and greater certainty of close
- Taxes: Companies that pay a lot of federal income taxes and shareholders with low basis who would otherwise pay a lot of capital gains taxes often look at an ESOP alternative amongst their considerations
Q: Are there any instances when an ESOP is not a good idea?
Mary: Of course. ESOPs represent less than 10% of middle market M&A. So it’s more often the case that an ESOP is not the right fit. Examples include:
- Start-up businesses
- Poor performing businesses
- Sellers who want to maximize cash at close
- Companies that could attract a significant market premium (related to their industry or synergies)
- Companies that lack strong leadership
Q: What are common myths about ESOPs?
Mary: The most pervasive myths include:
- ESOPs can’t pay fair market value: ESOPs do pay fair market value. They do not pay a strategic premium
- ESOPs are too complicated: Selling your business is complicated. No matter what strategy you select, commit to working with high integrity, highly qualified and experienced advisors
- The employees will run the company: Employees do not run the company. Management runs the company and the board elects management, very similar to normal business governance
Q: What else should I know about ESOPs?
Mary: ESOPs can be a win-win-win. For the shareholders, they receive fair market value, a tax deferral opportunity, and the ability to continue to have equity upside. For management, there is the opportunity for management continuity and ownership stability, increased employee productivity, and tax advantages. For the employees, there is the opportunity to participate in the financial success of their company. Employees become more engaged, look for cost savings, and tend to stay with the company longer. You don’t have to take my word for it, watch this video about National Van Lines. You will hear not only from one of the owners but also employees about their feeling on the ESOP.