During these unprecedented economic times, the use of an ESOP can provide business owners a unique path to liquidity and increase the cash flow of the business. The goal of liquidity is a challenge in today’s market due to stricter underwriting standards by lenders and buyers cautiously approaching acquisitions.
A sale to an ESOP has unique characteristics not found in recapitalizations and traditional company sale transactions. These characteristics center on deferred capital gain taxes, elimination of some or all corporate income taxes, repayment of debt with pre-tax dollars, and a sale price that is not determined solely on the amount of leverage available to the buyer. The ability to increase cash flow in uncertain times is always an attractive feature to explore.
A Way Through
The ESOP is a buyer that is relatively agnostic to how much of the company is purchased. This allows the business owner to sell the proper amount to reach his financial objectives. With current valuations of businesses down in most industries, this partial sale can secure a portion of the liquidity that was sought by the owner. The remaining ownership can be sold when the owner feels the market place has less uncertainty and hopefully a higher valuation of the business. Depending on the ESOP structure chosen, the owner can pay an attractive 15% tax rate on capital gains or defer the gains through a 1042 roll over, and reduce the amount of corporate income taxes paid. This reduction in income taxes increases the cash flow of the company which can be used to finance the operations/growth of the business or repay ESOP debt.
Another option would be for the owner to sell all the business to the ESOP and lock in today’s value of the company. In this scenario, the owner will need to provide seller financing. The seller would typically receive a note with an attractive current interest rate (8%) from a company they trust and detachable warrants that give the owner a stake in the future value increase of the company. If the company sold is taxed as an S-corporation, then there are no income taxes paid after the sale since the ESOP in non-tax paying entity. Just imagine not paying income taxes and using all those funds to finance the business, repay the seller note or both. In these competitive times, this extra cash flow can help the company compete more effectively for business.
The purchase price of a company sold to an ESOP is determined by a valuation approach that focuses on the “Fair Value” of the business. In today’s market place, many offers for companies are strongly influenced by available debt and not the economic return created by the business. This can lead to a lower purchase price than offered by the ESOP.
In these difficult times there are still liquidity strategies that can achieve the desired liquidity for the business owner. The sale of stock to an employee stock ownership plan is one of the most flexible and effective of these strategies.