Why Third-Party Transactions Fail and How an ESOP Transaction Could Prevail

February 14 2023 | 3 Min Read Time

Eric Zaleski

E: ezaleski@pcecompanies.com

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Plans do not always work out. This is true in life, in business, and in the process of transitioning out of your company. Specifically, selling your company to a third party may not go as planned — for a variety of reasons. One attractive alternative is selling to an employee stock ownership plan (ESOP).

Below, we outline the top five reasons third-party transactions fail and why you should consider an ESOP instead.

1. Changes in market conditions

Market conditions fluctuate from year to year, and so does interest from acquirers. For example, a buyer could have a change of heart if an existing portfolio company has recently experienced trouble. If they have an investment in a troubled company, they’re likely to put the brakes on a transaction within the same industry.

Another issue is that investors require funding, and most transactions are leveraged in some capacity with bank debt. When markets are uncertain and interest rates rise, that capital becomes more costly and less of it is available. Under those conditions, third-party buyers might decide they won’t receive their desired return on investment should they acquire your company.

Selling to an ESOP, on the other hand, can satisfy your needs even in times of market uncertainty and higher capital costs. An ESOP allows you to exit over time, and if bank financing isn’t available, the selling shareholders can fund the transaction themselves through a seller note. The note will provide monthly cash flow at an attractive interest rate.

2. Lack of agreement on terms

In all transactions, negotiations are top of mind for all parties. Robust due diligence will take place, and independent auditors typically perform a thorough review of the financials and operations. A third-party buyer could use this report to narrow down their offer, which could be different from that stated in their letter of intent and one you’re not comfortable with. If you and the seller are unable to agree on the terms of the transaction, the deal will not go through.

While an ESOP is also a negotiated transaction, it tends to be a more cordial process. Due diligence still happens but is not usually as intense as the process involved when selling to a competitor or private equity firm. This is evident in the typical time it takes to close an ESOP transaction (four to five months) versus a third-party sale (seven to nine months).

3. Willing buyer

Even if you’ve built a successful company, you may have difficulty finding an acceptable buyer. For example, perhaps you’d prefer not to sell to a company that is likely to lay off a significant number of your employees. Or you might not find a suitable buyer simply because there aren’t many — either because of market conditions or because of legal or regulatory issues that currently make the purchase a risky investment.

Even when market conditions change and buyers pull back, the ESOP remains a buyer of stock at any time. Additionally, ESOPs can own whatever percentage the shareholders decide to sell. The ability to sell a minority position, and retain equity upside, is an advantage over selling to a third party, which will likely require a majority or even 100% sale of your company.

Read more about partial ESOPs here: When to Consider a Partial ESOP

4. Tax advantages

Third-party acquisitions are usually structured as an asset sale, which is favorable to the buyer. This presents potential tax implications for you, the seller, which could reduce your net proceeds.

ESOPs are stock transactions, which provide you and your company with many tax benefits. If the company is or converts to a C-corporation, then you, as the selling shareholder, have the ability to defer all your taxes, making it a 100% capital gains tax-free transaction. If the company is an S-corporation, the percentage of the company that the ESOP owns is tax free going forward. For example, a 100% S-corporation ESOP is entirely income-tax free. Since the company is not paying taxes, it has increased cash flow available to repay ESOP transaction debt, which is attractive to capital providers.

Read more about ESOP tax advantages here: ESOP Tax Incentives for Selling Shareholders

5. Company legacy

Building a company from scratch is something to be proud of, and business owners often want that legacy to continue. You can’t be sure of that with a third-party transaction, which cannot guarantee that the company will keep its culture for future generations.

If company legacy, culture, employee retention, and operational control are important to you, then an ESOP can be a better choice, as it will preserve these attributes. ESOPs are guaranteed to keep the name on the door, the location, the company commitment to its community, and the company culture. Employees will maintain their positions and should not expect mass layoffs in an ESOP transaction. Executive management can also expect to run the company in the same manner as they do today. In a third-party acquisition, in contrast, the company may relocate or restructure operations post-close. While a change may not happen immediately, the new owner will have the ability to make changes at any time.

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Selling to a third party is not the right choice for everyone. While that is also true for an ESOP sale, its many positive characteristics — the ownership options, tax benefits, friendly process, and certainty to close, among other benefits — make it an attractive option. And if unfortunate circumstances arise in a third-party sale process, considering an ESOP as an alternative can allow you to achieve your goals.