ESOPs are an effective business exit strategy for business owners who want to retain some degree of control over their exiting of the business. An ESOP allows the business owner to transition out of the business at their own pace, ensure business continuity, and protect company culture.
How Do ESOPs Work as Exit Strategies?
An ESOP as an exit strategy works by creating a ready market in which an owner can sell their ownership interest in the business in the form of company stock or shares. It’s a way for owners to cash out from the business without having to find a buyer or sell the business in the open market.
For many small business owners, most of their personal wealth is tied up in the business. When they want to retire, they have to sell the business to access those financial resources. If the business is a private company, there might not be a market for the stock. That means the business has to be sold to an outside buyer, which may be hard to find. Even if a buyer is found, there is no guarantee that the business will continue to operate or that current employees will retain their jobs. This can be emotionally difficult for business owners who have spent their lives building up the business and do not want to see it shut down.
ESOPs offer an alternative. They allow the owner to sell the business back to the company itself by granting ownership shares to the employees via an ESOP trust. The trust buys the company at fair market value and then allocates ownership shares of the business to ESOP participants which are the company’s employees.
As a result, the business gains new owners who have a vested interest in seeing the company succeed and the exiting owner receives fair market value for the business along with the guarantee that the business will continue after they retire.
Benefits of Selling to an ESOP
The selling owner, the company itself, and the employees all benefit from selling a business to an ESOP.
Benefits for Sellers
An ESOP benefits the business owner in several ways. Primarily by creating an immediate market for their business stock. Other benefits for sellers include:
- Receive a fair market sales price
- Ensures the continuity of the business legacy
- Allows employees to keep their jobs
- Provides greater control over the exit transition
- Potential for tax benefits, such as deferral of capital gains tax
Benefits for Companies
The business itself benefits from the ESOP in the most obvious way: continuing to exist. Additional benefits for the company itself are:
- Federal tax advantages for S-Corps and Corps
- Powerful recruitment and retention tool
- Greater loyalty and improved productivity due to employee investment
Benefits for Employees
Employees become part owners of the company when they participate in an ESOP. This can create a deeper connection to the business and greater investment in the business’ success, no matter what level of the organization the employee works. This creates an ownership culture that supports business success. Other benefits are:
- Retirement benefit available at no-cost or employee match
- Financial rewards for business success
- Long-tenured worker loyalty is rewarded
Challenges Facing an ESOP
While ESOPs present many opportunities, they are also complex and are not always the best option for every business. Two of the biggest challenges to an ESOP are ensuring compliance with federal rules and regulations under ERISA and having enough cash on hand to buy shares back from retiring employees.
Employee Retirement Income Security Act
ESOPs are subject to the Employee Retirement Income Security Act (ERISA). ERISA
regulations are overseen by the Department of Labor (DOL). ERISA and DOL enact strict requirements on ESOPs to ensure participants are treated fairly and that the ESOP trust is managed appropriately, particularly in the amount it pays for share prices. Noncompliance can be financially devastating for an ESOP, even to the point of reversing the transaction and disbanding the ESOP.
One other challenge that ESOP sponsors must navigate is ensuring the trust has enough liquidity to buy back the shares from retiring employees and/or employees who leave the ESOP after vesting. This repurchase liability must be planned for to keep the ESOP trust solvent.
An ESOP is not the only exist strategy available to retiring owners, though it is the closest to home. Owners who want to exit their business could alternatively:
- Find a third-party buyer. Typically, an investment banker is hired to help find a suitable buyer for the company. The selling company pays a percentage of the final sales price as the banker’s fee.
- Sell to a private equity firm. A private equity firm may be interested in the business, but they tend to expect a certain return on their investment. This makes them very strategic and selective in the businesses they purchase or invest in.
- Sell to a competitor. If the business has competitors, a merger or acquisition might be the easiest sale simply because competitors want to gain the market share and customers or eliminate the business from the competition.
- Sell to key employees or family members. Management buyouts are an option when key leaders have the funds to buy the stock or are willing to take on debt to do so. Similarly, the business could be sold to family members.
In all of the above situations, the exiting owner has far less control over the transition process and the future of the business than they have with an ESOP.
Learn More About ESOP Feasibility at Aegis Fiduciary
ESOPs as an exit strategy are becoming more and more popular as baby boomers retire and as the workforce and consumer cultures prioritize employee well-being and benefits. For business owners who want a say in how their business moves forward without them, an ESOP as an exit strategy makes the most sense. ESOPs allow owners to protect their legacy and their employees while also securing their retirement, gain tax advantages, and diversify their retirement funds.
Is an ESOP the business exit strategy for you? Find out by speaking with Aegis Fiduciary. Schedule a consultation to discuss our ESOP transaction and ESOP trustee services.
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