ESOP’s As Internal Buyers Of Your Stock Company

This article is focused on helping business owners and their advisors understand Employee Stock Ownership Plans (ESOPs) and how they can assist in developing effective Exit Strategies from a business. Even with today’s vibrant Mergers and Acquisitions marketplace, many business owners continue to ask about ESOPs as ‘internal buyers’ of their Company stock.

Many ‘ESOP oriented’ business owners realize that their businesses are inherently difficult to sell and are interested in diversification of their personal wealth away from their illiquid businesses. Others simply want to know about the tax savings that the Internal Revenue Code allows when working with these plans. And some business owners are interested in rewarding management and key employees.
ESOP benefits include the following:

• Tax-deferral of Capital Gains: Section 1042 of the Internal Revenue Code allows for the avoidance of capital gains on the sale of stock to an ESOP. Certain rules are required to be followed with this ‘rollover’ strategy, but it is possible for some corporations to sell stock and avoid capital gains taxation in the year that the sale is realized. Under current Estate Tax laws, the gain may be permanently avoided if the assets are ‘stepped up’.

• Non-cash Tax Deductions for the Company: As a defined contribution plan, the ESOP allows a Company to make non-cash contributions to an ESOP that reduces its current level of taxable income.

• Diversification for the Business Owner While Maintaining Control: This ‘internal’ transfer strategy allows a business owner to diversify any amount of their illiquid holding in the business while still maintaining control and drawing salary and other perquisites of ownership. By contrast, ‘External’ transfers almost always require selling a ‘controlling’, or majority, position in the Company.

Another benefit to an ESOP is the possibility that the employees will appreciate the value of their productivity and change their behavior on the job. Employees will receive small amounts of non-voting shares of stock each year into their ESOP account (remember that it is the ‘sharing’ of this stock ownership that allows the tax benefits in ESOPs). So, if the Company rises in value, employees will see this represented in their annual valuation. Often times this serves the purpose of encouraging more productivity at work through a sense of ‘ownership’ in the Company’s fortunes.

The primary disadvantages of ESOPs are the initial set up costs and the [often times] use of leverage in financing the ESOP.

Both of these disadvantages are mitigated by a few important facts. First, a sale of the Company to an ‘external’ buyer usually involves a much more expensive intermediary. And second, the use of debt is often a very inexpensive form of financing because it allows the business owner to retain a majority of the equity/ownership in the business. This means that the business owner maintains control of future profits in the business. And, many business owners are pleased to learn that the installation of an ESOP does not preclude that owner from later selling the business to an ‘external’ buyer.

For all of these reasons, ESOPs are powerful planning vehicles for Exit Strategies.

So, for a ‘controlled’ and ‘partial’ monetization strategy from a business, an ESOP can be just the right fit for a business owner looking for personal diversification, but not quite ready to give up control of the Company.

Exit Strategies are hard to design and even harder to properly execute. I am pleased that you are pursuing a pro-active interest in Exit Strategies because a pro-active approach to an Exit Strategy is the only approach to a successful Exit Strategy.

© 2007 John M. Leonetti