Employee Stock Ownership Plans (ESOPs) have been in the news (and in the pages of CONTRACTOR) more frequently the past few years, and two trends seem to be driving their popularity.
First, as an entire generation of plumbing and heating professionals prepares to retire an ESOP can be an important basis for a succession plan. Second, as the industry continues to struggle to attract skilled workers, an ESOP is one more incentive to help attract trained, quality employees.
But what exactly is an ESOP—and how does it work? What are some factors that could make it right for one business but not for another? How long and involved is the process of setting one up? And what exactly are the tax implications?
For answers, we turned to Jeff Buettner, Managing Director at ButcherJoseph & Co. ButcherJoseph is a full-service investment bank that specializes in ownership succession transactions. Buettner has over 20 years of valuation and financial opinion services experience. He has served as a member of the Board of Directors of the National Center of Employee Ownership (NCEO) and is a member of the ESOP Association where he serves on the Valuation Advisory Committee.
CONTRACTOR: Jeff, thanks for speaking with us today. For our readers who may be unfamiliar with what an ESOP is and how it works, can you give us the basic run-down?
Jeff Buettner: Essentially it is a structure that allows for employees of an organization to have a participation in the equity of an organization, a sponsoring company in concept. It is a trust that allows for participants to be beneficiaries of that trust, and a structure that allows for them to have an allocation of a sort of stock that gives them the experience of being a direct stockholder.
It’s technically a retirement plan that’s governed by ERISA [the Employee Retirement Income Security Act], and so a lot of the same types of rules and provisions that pertain to an ESOP also pertain to a 401k. So there’s some similarities, but there are also some important differences.
In an ESOP, employees don’t contribute any cash out of their paychecks. It is a benefit that the employees get from the company without having to put in any dollars. And then the sole investment of that would be in the employing corporation itself. So that individual would have an investment in just the corporation. It’s not allocated across a broad basket of say, mutual funds.
CONTRACTOR: What are the advantages of an ESOP for a business owner doing succession planning who thinks their employees are the best people to give their company to?
Jeff Buettner: An ESOP provides an avenue for the owner or the current owner of the organization to sell his or her ownership interest and his or her business through his employees. This is really an opportunity to sell your business to a trust that provides for a broad-based benefit for all employees. And so, because all employees now have this participation, obviously it can be a valuable tool for that company to retain their employees. And in a contractor-type business model, obviously one of the big assets of your organization is your people and those people that provide services to the customers.
And so having this ownership stake in the business can be a powerful incentive for retaining your employee base. It can also be a very valuable tool for recruiting future employees at all levels of the organization, and it’s a very powerful way for your employee base to have a chance to build wealth that otherwise may not be possible just through traditional 401k-type contributions.
It’s important to understand that the trust is the owner of the stock. If you have a hundred employees, those hundred employees are beneficiaries of that trust, so they individually don’t have individual rights to vote the stock, nor do they have individually opportunities to select management or run the business, so to speak. Those types of governance provisions are still at the senior leadership level and more even specifically at the board level.
CONTRACTOR: I understand that an ESOP offers some interesting tax incentives?
Jeff Buettner: Well, number one, there’s an opportunity for the selling shareholder through the transition of their business to potentially defer capital gains taxes that would otherwise be due on the sale of the business.
Number two, depending upon the structure that’s used, there’s an opportunity for the corporation on a go-forward basis to now be owned by a tax-exempt shareholder and therefore be shielded from federal taxes that would otherwise typically be payable under other ownership structures. There are some really interesting tax attributes as well from a number of different perspectives.
CONTRACTOR: So, say you think an ESOP might be right for your company, what are the first steps to take?
Jeff Buettner: The first thing is to determine if you’ve decided to go that route—if you want to sell your business to the ESOP rather than any other buyer. The next step is determine how feasible the structure is for your business. And a big part of that is understanding the value of your company. Part and parcel with that is understanding, well, how is this ESOP going to finance the purchase of this business from me?
At its core, this is a leveraged buyout and like any other leverage buyout, you have to be able to support the debt structure that is used to finance this purchase transaction.
A big part of whether or not this structure is feasible isn’t just centered around what the company’s worth, but is how is the company is going to, through its cash flows, be able to pay the debt that is placed on the company’s balance sheet in order to finance the purchase price.
Obviously it’s important to look what sort of debt is available, the terms of the debt, the company’s projected cash flows, what the annual principle and interest payments on that debt are going to be alongside other cash needs of the business.
Your business probably will have capital expenditure needs, it will probably have working capital needs, you might have, again, strategic initiatives at the board level to grow organically, and you’re going to need cash. You might have aspirations at the board level to grow inorganically through acquisitions, in which case you’re going to need cash, you’re going to need borrowing capacity. So you want to make sure that you can sort of marry all of the productive growth initiatives of the business alongside the fixed charges you’re going to be taking on to finance ownership succession.
We tend to try to think about the durability of the structure upfront and then really sort of try to explain and illustrate to the founder or the owner of the business that is selling the company, this is the experience that you can expect initially and over a longer say, five, seven year period of time; here is the experience that the employees can expect initially and over a five or seven year period of time.
CONTRACTOR: Naturally, an owner would want expert advice along the way.
Jeff Buettner: I think the most common forms of ownership succession are selling to private equity or selling to a strategic buyer (typically meaning a competitor). I think the ESOP structure sometimes is a really good fit that goes overlooked because there just aren’t a lot of practitioners that feel confident in the nuances of the structure to really sort of dig in.
I think it’s important then for owners to make sure that they’re being proactive. If the ESOP is not something that someone is mentioning to them, they should be proactive asking about it to make sure that when they’re making a decision to sell their company, they have all of the information on the options that exist for their business.
Like anything else, you hate to make a decision on a route not knowing that there was an alternate route that was feasible and competitive and—in some cases—more competitive and more attractive for a lot of reasons.