Today’s most powerful and flexible business ownership structures often include some element of employee equity participation. For several decades, a particular type of such structure has enjoyed tremendous federal and state statutory income tax advantages for owners and companies: Employee Stock Ownership Plans (ESOPs). Under an ESOP structure, owners can in some cases defer (sometimes permanently) capital gain taxes, while companies can reduce and even eliminate any income tax obligation on business operations. ESOPs can be part of an exit strategy and/or a growth strategy. Questions often arise as to the characteristics of good ESOP candidates. This post briefly summarizes certain of such characteristics.
Number of Employees
Most advisors generally prefer to see 40 or more full time employees, although some successful ESOPs have fewer employees. A stable work force can be a positive. ESOP transactions for companies with fewer than 25 or so employees, while sometimes viable, can become difficult and perhaps inadvisable, especially if there is high turnover.
Size of Business
A minimum equity value of $4-$5 million is a good benchmark because there are many professionals involved, and the fees on the low-end of a leveraged ESOP transaction will generally exceed six figures and move upwards depending on the complexity and amount of financing. A pay-back analysis can be helpful, e.g., a company generating taxable income of $1 million and paying corporate-level or owner level taxes of $400,000 may typically recover $200,000 in transaction costs through tax savings in about six months.
ESOPs tend to work best for companies where the selling owners want something more than just a partial or complete exit. Here are some “softer” seller objectives that may not be addressed by a traditional sale:
- They are not ready to sell the entire company and want/need to monetize some of their investment in a highly tax-efficient manner.
- They want to remain active and in control of the business, while accessing ESOP benefits.
- They want to perpetuate the company as an independent enterprise, and they are not interested in selling to a strategic or to a private equity buyer.
- They want to enhance a stable, profitable company’s pre-tax and after-tax growth pattern.
- They want to make sure that the employees continue to have a good place to work and a good retirement.
Types of Industries and Businesses
ESOPs can work well for virtually any company, but they generally work best for companies in stable industries and companies. They work well for worker-intensive businesses, such as staffing, consulting, and architecture and engineering firms. Cost-plus government contractors are especially good candidates. ESOPs can be a great acquirer for companies that are difficult to sell. The company should have sustainable management.
- C corporations – Profitable C corporations tend to be excellent candidates because the sellers readily qualify for the capital gain tax benefit, as it applies exclusively to C corporations; some restructuring is necessary for S corporation and LLC structures to qualify. A C corporation is also usually positioned to very quickly reduce or eliminate the income tax on ongoing operations.
- S corporations – S corporations can make very good ESOP candidates; a large percentage of ESOP companies are S corporations prior to the transaction. S corporation owners sometimes face a tradeoff between maximizing owner tax benefits versus company tax benefits. Modeling various scenarios in light of the owners’ objectives informs the decision.
- LLCs – LLCs make very good ESOP candidates as well. An LLC must incorporate to qualify for an ESOP transaction, but the incorporation transaction is usually very straightforward and tax-free. This provides the ability to close an ESOP transaction as a C corporation and allow the capital gain benefit for the owners. The company can then maximize its tax benefits.
CFA ESOP Capabilities
CFA is well-positioned to assist clients in evaluating whether an ESOP transaction can be beneficial. Unlike many traditional investment banks, we can efficiently compare and contrast partial or complete ESOP alternatives, with their superior after-tax economics, to other alternatives, including continuing the status quo. And we have a deeper, broader skill set than ESOP boutiques. We take an agnostic approach, focused on what’s best for the client. Finally, our FINRA-compliant platform also distinguishes us in the marketplace. Contact your CFA advisor.
Posted by Mark Klopfenstein.