While the M&A market continues to recover, business owners are utilizing Employee Stock Ownership Plans (“ESOPs”) to satisfy the need to convert some of their illiquid privately held company stock into cash and other liquid investments. The ESOP is attractive due to significant tax savings to the owner and company, flexible deal structures and speed with which a transaction can be completed. With higher capital gains taxes looming in 2011, now is a great time to evaluate this liquidity strategy.
The flexibility of a partial sale to an ESOP provides business owners the ability to:
- Sell a portion of the business
- Save taxes; both personal and corporate
- Motivate and retain employees
- Retain upside in the business
Consider John Doe, a 50 year old owner of an electrical distribution company in the southeastern United States. John started the business 15 year ago, has achieved fantastic growth but a recent fall off in the business has John interested in exiting the business completely at age 60 (10 years from now). However, the stresses on his business and decrease in his net worth have him concerned about his personal liquidity and financial security today.
John and his advisors examined several different liquidity strategies; a leveraged recap, a sale to an outside equity investor and a partial sale to an ESOP. After careful consideration, John decides to pursue a partial sale to an ESOP for several reasons: better financing alternatives, his ability to retain control, the benefit to his employees, and both personal and corporate tax savings.
The market has shown signs of life with banks recently lending approximately 2x – 3x cash flow on partial ESOP transactions. John receives offers from senior lenders in the $7-$10 million range as well as offers for another $5-$7 million of subordinated debt. John and his investment banker decide to limit the outside debt to $10 million; which equates to approximately 33% of the value of the business. John also decides to offer another 10% of the business directly to the employees through their 401(k) accounts, for a total liquidity event of $13 million for John. After the transaction is completed John will own 57% of the business and the employees will own 43% through the ESOP trust.
Not only has John been able to take some cash off the table with this strategy, he has also been able to defer the capital gains taxes on the sale. Since his company is a C-corporation, John has the ability to sell his shares to the ESOP and defer all of the capital gains taxes. If the company was not a C-corporation, he could convert to one before the ESOP Transaction and still enjoy the capital gains deferral. Another nice feature of ESOPs is that any corporate structure allows repayment of debt with pre-tax dollars which is a huge advantage in doing a re-capitalization through an ESOP.
With the ability to create an ESOP and complete a transaction in a shorter time frame than a sale to an outside buyer, a current business owner can be sure that they can sell some of their stock in 2010 while the capital gains rates remain at 15%. With no one expecting them to go lower, this can be a powerful savings to the business owner.
While Mr. Doe has been able to solve his desire for liquidity he has also realized several other benefits in the process:
- Employees have a greater stake in the business; now thinking like owners
- Succession plan in place
- Management team’s readiness is attractive to future buyers of the business as well as lenders
The flexibility and benefits of a partial sale to an ESOP are incomparable in today’s market place and should be considered as a liquidity strategy, especially with an increase in capital gains tax looming.