Business owners looking to exit are often faced with the following dilemma: cashing out at a reasonable price is very important, but they don’t want their business swallowed up by a large industry player eliminating the identity of the business they have built. They are concerned that their employees are treated fairly as well. Business owners in this situation often weigh the benefits of a sale to an Employee Stock Ownership Plan (ESOP) versus a sale to an outside buyer.
An ESOP is a very specialized type of IRS sanctioned qualified retirement plan. It is the only retirement plan that is permitted to own a concentrated amount of stock in its corporate sponsor. ESOPs have been specially designed so that employees can effectively own stock in their employer. The federal legislation establishing ESOPs was specifically designed to encourage employee ownership. When you read in the business press about “employee owned companies” they are probably talking about ESOPs.
ESOPs hold great attraction to business owners looking to sell. In order to encourage the development of ESOPs, Congress established some terrific tax benefits for owners selling their business. Most importantly, a business owner can sell her company to an ESOP and elect to defer all federal tax on the sale. To do this, the owner is required to invest the sales proceeds in a portfolio of publicly traded stocks and bonds of U.S. companies. Also, since an ESOP is a tax-exempt organization, if the company is an S Corporation, to the extent the ESOP owns the shares, the company is not subject to tax on its income.
Let’s consider a real life example (with the names changed). Jones Manufacturing produces a medium technology product that it sells to the military, pharmaceuticals, and oil and gas industries. Its non-military customers are Fortune 1000 companies. The company owns intellectual property in the form of industry certifications for quality and effectiveness of its products that are highly sought after and difficult to obtain. Sales are about $15 MM and EBITDA (Earnings before Interest, Tax, Depreciation & Amortization) is about $2MM. The company has 55 employees including 11 engineers and others with a high level of technical proficiency. It has received a purchase offer from a large competitor of $14MM with 90% of the cash at closing with the rest (subject to certain contingencies) payable within 18 months.
The owner has built this company from modest beginnings over 20 years with the help of a core group of key employees who have been with the company for more than 10 years. In particular, the company has a general manager who is capable of running the business and works with most of the key customers. Another key employee runs the service department which is very profitable and important for customer retention. The owner emphatically wants to see the employees benefit from any sale transaction. However, the prospective buyer is likely to move the research and development operations to its main facility about 200 miles away while maintaining a production and assembly line at the current location (for now).
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