When Conventional Wisdom is Wrong

Conventional wisdom is that an ESOP is almost always inferior to a strategic sale. The common view: an ESOP (Employee Stock Ownership Plan) provides liquidity at a painful discount. Real owners sell to strategic buyers, financial buyers or executives. Only the desperate use ESOPs.

Conventional wisdom can be a blunt object. The truth: the ESOP option can be a truly competitive choice for owner liquidity and value.

Maximizing Shareholder Value

Here are five clues that an ESOP could be a winner for you:

1. High cash flow and no logical strategic buyer. Many very healthy companies do not have logical strategic buyers. One of our ESOP clients has contracts that can’t be transferred due to conflicts. Other ESOP clients have a non-transferable royalty arrangement. Others can’t novate government contracting set-aside contracts. An ESOP is often the most attractive buyer for a non-transferable cash cow.

2. Sell and keep control. Many owners cherish their identity as a business owner. Sell to a strategic buyer and you give up ownership and control. Sell to an ESOP and stay in control as the notes are paid off. Value is not all about money. Often a founder’s post-sale role and responsibility is what matters most.

3. Older owner. Do you know the IRS permits the rollover of capital gains on certain assets like real estate and C Corp business assets? Defer the gain till your eventual death and get a step-up in basis and avoid all taxation on the sale. If done correctly, you can even borrow against the rollover proceeds and use the assets however you like. It’s what you keep that matters.

4. Owner of C Corporation. Most strategic buyers want to buy assets, not stock, for tax purposes. Selling shareholders of a C Corporation are taxed twice: once at the C Corp level and then a 2nd time upon receiving C Corp distributions. By selling stock (not assets) to an ESOP and avoid double taxation. Savings: Avoiding the 15% tax trap of double taxation.

5. Greater Bank Leverage. Considering a management buyout? The sale to insiders is often limited by bank financing. Commercial banks will often lend 3X on a taxable company’s EBITDA (Earning Before Interest Taxes Depreciation and Amortization) versus 5X on a tax-exempt entity’s EBITDA (like an S Corp ESOP).That is $20 million more borrowing for a company with $10 million of EBITDA . 66% more bank financing matters.

Look before you leap

ESOP can be great for sellers. These same ESOPs can create complications for the insiders who now manage the ESOP, pay off the debt and seek to attract and retain the best talent with limited equity options. Many of these complexities can be reduced if managed correctly. So look and plan before you take the ESOP leap.

Bottom line: ESOP can be one of the most effective solution to unlock hidden shareholder value. Context is everything.

Want to explore more about ESOPs?

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ESOP text adjacent to a person next to a laptop