No sale in sight? ESOP offers way out of business
A change of tune is possible by considering an employee stock ownership plan (ESOP) as an option to selling outright. This is an opportunity for owners to take the first step toward a transition out of the business by selling at least 30 percent of their company to employees. The resulting cash can allow them to start making lifestyle changes toward retirement or shifting into another venture.
The time may be right to use this approach that allows owners to get money out of their businesses without giving up control. In today’s marketplace, this option can be less risky and more advantageous than selling to an outsider. And at a time when staffs have been downsized, this is a way for owners to say “thank you” to loyal employees for sticking with the company through a down economy.
Surrender vs. control
The market environment is different from a few years ago in two key ways. First, banks are not lending as much money to business buyers and private equity funds are paying less cash at closing. This has led sellers to cut deals with buyers for deferred payments. Second, the price that an outside buyer will pay for a business is lower today. Both impacts have made ESOPs a more favorable option.
Deferred payments can come in many flavors: a note from the seller, an earn-out tied to sales, royalties or consulting agreements. But if the business faces problems down the road, the seller can risk never seeing that money. Why not gain liquidity through a 30 percent ESOP where the owner is still in control of the future?
Depressed market values also bring ESOPs more in line with the sales prices of a few years ago or private equity valuations. In the past, a seller might get a seven-times multiple as a business valuation, based on earnings before interest, taxes, depreciation and amortization (EBITDA). A four-times multiple is more likely today, which is making blues singers out of owners who could have sold out for $21 million in 2007 but now can get only $12 million based on a $3 million EBIDTA.
The real challenge for business owners is the ability to maximize net after-tax return on the sale. Too many sellers just look at the top-line price. With higher risks and lower valuations in today’s market, it’s imperative to understand that an owner can actually receive higher net value proceeds through the deferral of taxes with an ESOP.
On a $12 million valuation, the tax treatment on an ESOP transactioncompared to selling to a third party could be more favorable. This isespecially true for ESOP owners continuing to receive salary, benefits,perks and other business deductions. Most experts believe that capitalgain tax rates will continue to rise, thereby making the ESOPtransaction more beneficial.
One potential drawback to an ESOP is the need to maintainpersonal guarantees. However, owners should ask themselves twoquestions to offset that issue: “Do I want to risk not getting my fullpayment by taking a seller note in exchange for not having personalguarantees?” Or, “Do I want to keep a hand in the business via an ESOPto ensure its future success for increased payouts and the possibilityof an outright sale when valuations are higher?” It’s the differencebetween surrender and control; most entrepreneurs prefer the latter.
Test before transition
Banks are tighter in their lending to buyers in this economy but highlysupportive of ESOPs due to historically low default rates, personalguarantees, and the stability of existing management. To be considered,business owners should have consistent earnings and cash flow toservice the debt to pay for the purchase of stock by the ESOP. Thismakes it an excellent option for many businesses, and especiallyservice businesses with stable clientele, which may be less attractiveto buyers seeking to leverage assets.
Owners should have high confidence in their management teams beforeusing the ESOP option as a first transition step out of the business.For the remaining value to increase over time, the stability andleadership potential of the employee base is an importantconsideration.
Take time to test key contributors by asking them to step upand perform. If they are capable, then the owner can hand off theday-to-day management and begin to slow down. If they are not, then anowner can bring in outside talent and continue managing the businessfor future success.
As with any important business transaction, there are advisersthat an owner should call upon to handle the complexities of an ESOP.
A business adviser can help tailor a vesting and eligibilityschedule designed to meet the owner’s goals of retaining key people toassure future success and attract new employees. Working with theinternal or external accountant, this adviser can develop a proposalfor bank ESOP financing and manage the process with the company’sbanker.
Legal support is needed to draw up the plan documents for theloan, sale of shares and trust agreement. Privately held companieswill need an independent appraisal that can be handled by a certifiedappraiser.
Don’t forget the humans
Communication with employees about the plan is equally important. Toooften, the human side of this transaction is downplayed. Employeesbecome shareholders and need to understand how to look at the businessas owners.
An initial celebration of the ESOP can begin this educationprocess. For example, one owner hired limousines and invited his entirestaff to a black-tie affair to create excitement in his transfer ofownership. But ongoing information and training help employees to learnhow the company makes a profit and their role in it.
There is room for creativity with ESOPs when owners decide thetime is right to exit the business and want a source of liquidity thatbenefits themselves as well as their employees.
