The amount you sell a company for and the money you actually net from the deal can be two very different things. That’s why an ESOP option, with potentially sizable tax benefits, can be a very attractive way to structure the sale of a printing or converting business.
ESOPs, or Employee Stock Option Plans, have existed in their current form since 2003. These profit-sharing plans were created by Congress to facilitate employee ownership of companies. They’re similar to other profit-sharing plans in that they have funding limits, as well as tax advantages.
The tax advantage benefits are particularly noteworthy if you’re an owner looking to sell your business. The big draw with an ESOP: You don’t have to currently pay taxes on the gains if you sell C-corporation stock and reinvest the proceeds into an appropriate security. That’s right. No taxes on the gains.
And those gains can be a significant amount of money, especially on a sizable transaction. Considering the capital gains rate can be anywhere from 24-30% (depending on your state and taking into account other taxes such as Medicare), ESOPs can be an ideal solution.
The tax benefits of ESOPs are an example of why the structuring of a deal can be more important than the price tag. With an ESOP, it’s possible that a company sold for $10 million could net an owner just as much as a company sold for $14 million without ESOP. (Of course, this is dependent on a wide range of variables, but the point is that the role of taxation is extremely important in a deal.)
How ESOPs Work
ESOPs are generally created when either an individual or a group of people has an interest in purchasing and running a business. For example, a group of executives may be interesting in creating an ESOP and purchasing the company from the owner. They would present the ESOP option to the employees.
Who wins with an ESOP? If the deal is structured right, everyone stands to benefit.
For the current owner selling the company, you can sell a minimum of 30% or all of your company to an ESOP, and realize potential significant tax deferral. You’d also have the satisfaction of knowing the company’s culture and current management structure could remain intact. The business you built would live on after you’ve transitioned away from it.
For the executives spearheading the effort, the ESOP could be structured to provide executive stock options. That’s an ideal scenario for these executives, as they wouldn’t be required to provide their own collateral to finance the deal (that may be derived from the employee contribution), yet they ultimately receive a percentage of ownership.
For the employees, the ESOP could be set up as an investment option for the employees, and they could use current retirement plan savings to buy into the program. There are a number of different ways this could be structured, but at its core, this is a retirement vehicle in which an employee can actually influence performance. Improve the company with your hard work, and you’ll reap the benefits as a partial owner.
What Types of Companies Are ESOP Candidates
Once again, I’m touching on some very broad strokes here, as a number of variables will influence an ESOP. But if you like the basic concept, then you need to determine if your company is a good candidate for an ESOP.
Generally, you want the following characteristics in an ESOP:
- Low seller tax basis in shares sold.
- Your company should be profitable, with good cash flow.
- You probably don’t want to be a big apex company in which you constantly are required to make hefty expenditures. This particularly applies to companies that have to make significant outlays on expensive equipment. Service-oriented companies that cash flow effectively are maybe more ideally suited.
- You have an individual or group of individuals who can spearhead the ESOP effort. These are not simple transactions. The modeling and the structure of the deal are critical, as well as how it’s presented to employees. You need exceptional people and outside professionals driving the ESOP who understand how the deal can work.
- You have hard-working employees who take pride in their company.
There is no one-size-fits-all ESOP program. Each deal is structured and modeled differently. I’ll be explaining some of these ESOPs nuances in future posts.
Many of you are familiar with ESOPs, and understand they’re a viable option. For others, this may be a revelatory find. With its tremendous tax benefits, it’s a win-win-win scenario – a win for the seller, a win for your new management team, and a win for your employees.