ESOPs vs. Third Party Sale - What’s the difference?
A commonly asked question that Centura Wealth Advisory receives is, “What is the difference between ESOPs and a sale of my company?”
The advantages of choosing to implement Employee Stock Ownership (ESOP) as a part of your exit plan, vs. selling your company to an outside entity depends on your specific situation.
ESOPs are available to C Corps and S Corps as a tax mitigation strategy to offset capital gains taxes. For those business owners who want to sell a part of their stake in a company, or in the case of one partner wanting to exit and the other(s) wanting to remain in control of the business when those remaining partners lack the desire to buy out the departing partner, ESOPs are a viable option.
Structuring your ESOPs sale is complex and outside the scope of this article, however, as a high-level overview of the choice between a straight third party sale to a competitor or venture capital/private equity sale let’s review the benefits of each type of exit.
What is an ESOP?
The National Center for Employee Ownership (NCEO) states that an ESOP provides “A variety of significant tax benefits for companies and their owners. ESOP rules are designed to assure the plans benefit employees fairly and broadly.”
ESOPs are Employee Stock Ownership Plans, as the name suggests, selling stock in your company to those employees who are already part of the organization. As a business owner, you may wonder how you can protect loyal employees after an exit. Certainly, a third-party sale leaves those who may have helped build your company alongside you vulnerable to termination or worse, the dissolution of their leadership role or disintegration of the company culture they helped build.
An ESOP not only protects loyal employees from termination but also gives them ownership of up to 100% of the company. From a tax perspective, ESOPs are valuable in that your seller notes earn on average 13% - 20% in contrast to the 6% average rate of return for stock market assets. When a business owner or owners sell to their employees, the transaction is tax-free. Here is an example of the structure of a cash sale vs ESOPS from The Menke Group:
“Let’s assume that the value of your company is $10 million and you decide to sell it to a third party for all cash. After paying a combined federal and state capital gains tax of say 30% (assuming a zero basis), you would be left with net proceeds of $7 million, which you could reinvest in [...] public stocks that historically earn 6% on the average over the long term.
In comparison, if you are a C corp. [...] you could sell your stock to an ESOP and receive $10 million in seller notes, tax-free, and your seller notes could earn an all-in rate of return ranging from 13% to 20% or more. Similarly, if you are a S corp. or switch to S corp. status, you could sell your stock to an ESOP in exchange for $10 million in seller notes, pay the capital gains tax on the installment sale basis and earn an all-in rate of return on your seller notes ranging from 13% to 20% or more.”
NCEO states that “ESOPS are most commonly used to provide a market for the shares of departing owners of successful closely-held companies, to motivate and reward employees, or to take advantage of incentives to borrow money for acquiring new assets in pretax dollars.”
Selling your business to a Third Party
For larger businesses (above $10 million in sale price) selling to a third party may be your best option. Larger sales often require the deep pockets of Private Equity PE) funds. Typically, larger companies have less concern for the future of their key employees. This may be because the owners have stepped away from the careful management of running of the business or because the hierarchy has become so stable that a purchasing entity would not touch the existing structure for fear of damaging the profitability of the acquired company.
The typical PE sale will give the seller a large portion of cash that they can allocate to whatever they wish. For example, they can give it to their family, buy a property, or invest as they wish without the long-term funds that accompany an ESOP. Being acquired by PE almost always means the owner stays on to ease the transition with a decreasing amount of influence over the subsequent 1-3 years.
Selling to a competitor can mean a lower sale price but likely the retention of your service offerings and potentially the merging of your company culture into the new entity.
From a tax perspective, selling to a third party means you will have to pay capital gains taxes on the full sale price of your company. For some sellers, this is a necessary evil and there are ways to offset those capital gains taxes such as:
- An Installment Sales Agreement. An Installment sales agreement allows a buyer to pay a part of the sale price annually allowing them to adjust their annual income to maximize tax savings.
- An Asset Sale keeps the company’s ownership in the hands of the seller to earn on the various components of the business as opposed to the entire business. In an asset sale, the seller may be able to write off the purchase more effectively though it leaves vulnerabilities for the seller.
The Pros and Cons of ESOP
Some of the main ESOPs uses are:
- “To buy the shares of a departing owner. Owners of privately held companies can use an ESOP to create a ready market for their shares. Under this approach, the company can make tax-deductible cash contributions to the ESOP to buy out an owner’s shares, or it can have the ESOP borrow money to buy the shares.
- To borrow money at a lower after-tax cost. ESOPs are unique among benefit plans in their ability to borrow money.
- To create an additional employee benefit. A company can simply issue new or treasury shares to an ESOP, deducting their value (for up to 25% of covered pay) from taxable income.
- Major tax benefits. Some of these tax benefits include: contributions of stock are tax-deductible, cash contributions are tax-deductible, contributions used to repay a loan the ESOP takes out to buy company shares are tax-deductible, and sellers in a C corporation can get a tax deferral.”
The potential downside of ESOPs from NCEO include:
- The law does not allow ESOPs to be used in partnerships or in most professional corporations.
- ESOPs can be used in S corporations, but do not qualify for rollover treatment.
- Private companies must repurchase shares of departing employees, which can become a major expense.
- The cost of setting up an ESOP is substantial—$40,000 for the simplest plans.
- Any time new shares are issued, the stock of existing owners is diluted.
Which is best for you?
ESOPS are complex structures as are sales of businesses to third-party buyers. While we can’t tell you which is right for you, the important aspect of a well-planned exit is a holistic view of the company, the owners’ wishes, and the timetable. As you plan for your company exit, please reach out to one of our trusted advisors to learn more about structuring an exit at 5 years, 3 years, and into the final 6 months before your sale.
As you look to plan for the future of both your personal finances and business finances, it’s important to understand what kind of financial assistance you may need. Understand the difference between a wealth manager and a financial advisor and which role is right for you in this blog.