Employee Stock Ownership Plans (ESOPs)

Robert Buchanan, ASA, CFP®

types of technology

Bob Buchanan
National Practice Leader, Business Transition Planning
Comerica Wealth Management

Employee Stock Ownership Plans (ESOPs): How Does an ESOP Work and Does an ESOP Make Sense For You and Your Company?

Key Takewaways: 
  •  Understanding how much money you will need to live your life is essential.
  •  ESOPs provide flexibility for sellers.
  •  It is possible to achieve certain tax advantages with an ESOP.
  •  ESOPs can create an ownership culture for employees.
What is an ESOP? 

An Employee Stock Ownership Plan, or ESOP, is a "qualified plan" regulated by the Employee Retirement Income Security Act of 1974 (ERISA). ESOPs are a benefit to employees and are designed to invest primarily in the stock of their employer. From a more practical standpoint, an ESOP is a tax-advantaged way to sell your business.

How Does an ESOP Work? 

Selling to an ESOP entails the creation of an ESOP Trust and an ESOP Plan. The ESOP Trust will hold the ESOP's shares for the benefit of the employees and will act in accordance with the established ESOP Plan. As the owner of the business, you can sell as little or as much to the ESOP Trust as you wish. In addition, selling a portion of your ownership to an ESOP does not necessarily preclude you from pursuing other transition alternatives in the future. The flexibility this provides is an important aspect of considering this alternative.

"There are many ways to transition from your business. Some owners wish to keep their companies in their families or transfer ownership to employees. Others hope to sell their businesses and capitalize on the value they have created. Although you may have many options available to you, an ESOP may present an opportunity to achieve several different goals." --Bob Buchanan
What to Consider? 
  • In contemplating whether selling to an ESOP is an acceptable option for you, there are a number of questions to consider, including:
  • What are your financial needs?
  • What are your non-financial objectives?
  • How much involvement in the business do you want in the future?
  • How important are topics like legacy, employees, and family participation to your goals?
  • How much risk are you willing to take going forward?

These same considerations will help you determine how much to sell and when.

Assessing Your Needs and Objectives 

As with any business transition conversation, the place to start is your personal financial needs. Understanding how much money you will need to live the remainder of your life in the manner you wish is what should drive all subsequent decisions. If any particular alternative doesn't provide you with sufficient proceeds, other alternatives should be considered. The best way to know how much money is sufficient - and whether a sale will meet that financial requirement - is to engage in personal financial planning.

Once you're confident that selling your company will satisfy your financial needs, it is prudent to consider your non-financial objectives. These could include your continued involvement with the business, providing for children, providing for employees, protecting your company's legacy, or reducing your risk. Identifying and addressing your non-financial objectives is an important step in determining what transition option is best for you.

Start with your personal financial needs.

Consider Your Role 

Unlike many other transition alternatives, ESOPs can provide flexibility around your continued involvement in your business and the role you will play. Because it's possible to sell less than a controlling interest to an ESOP, it is possible for you to retain control of your company after the sale. This provides the opportunity for you to continue in your current role or to change it while maintaining ownership. In some cases, you may even be able to sell a controlling interest in the business and remain in your current role. This flexibility is somewhat unique, in that you have the ability to decide for yourself.

ESOPs can provide the opportunity to continue your current role or to change it while maintaining ownership.
Understanding the Structure and Risk of the Transaction 

Unlike selling to other types of buyers, an ESOP transaction can often be fine-tuned to meet your risk and structuring desires, within limits. In many ESOP transactions, new debt funds the purchase of the selling owners' shares. This debt can be senior bank debt, mezzanine or sub-debt, a note held by the seller, or a combination of any or all of the above. Depending upon what portion of the company is exchanged in the transaction, the seller may have to hold a note for some amount. Therefore, the risk related to this type of sale could be greater than the risks associated with selling outright to an outside third party because payment is dependent upon future company performance.

In addition, with the flexibility of an ESOP comes complexity. Unlike selling to an outside third party, selling to an ESOP requires ongoing administration and oversight. Because an ESOP is a qualified plan under ERISA, there are certain administrative requirements, including annual valuations, record-keeping, and government filings.

ESOPs also come with an obligation to purchase the shares of plan participants under various scenarios, like the employees' retirements. This ongoing financial obligation is an important consideration and should be thoroughly analyzed during the pre-sale planning process.

Tax Considerations 

Perhaps the most unique attribute of ESOPs is the tax-related opportunities for both the company and the selling shareholders. If structured correctly, sellers may have the ability to reinvest their proceeds and defer the capital gains tax that would be due on the sale of their shares - potentially indefinitely. Likewise, under certain circumstances, it may be possible for the company to eliminate future income taxes. While achieving these results requires planning and the use of specific structures, the potential tax benefits can be a powerful incentive for owners/sellers.

ESOPs may provide tax-related opportunities for both the company and the selling shareholders.

Other Employee and Company Benefits 

Finally, one of the benefits of selling to an ESOP is it may preserve your legacy within your company and provide for your employees in ways that other transitions may not. An ESOP provides ownership to the employees of a company, often instilling a sense of responsibility and accountability that non-owners don't experience. The preservation of company culture is often a priority for transitioning owners who sometimes fear that selling to outside buyers will damage what they've built. Selling to ESOPs may help to ensure that companies continue to operate consistently into the future by preserving and empowering existing management teams and employee bases.

Navigate the Sale to an ESOP with Comerica 

The process of transitioning from your business can be daunting, and for many business owners, the thought of transitioning from their businesses is downright overwhelming. Even knowing where to begin can be difficult.

The most important thing is to plan as much as possible so when the time comes, you are ready. For some, selling to an ESOP may be the best way to transition and meet their goals, both financial and non-financial. It's impossible to discuss all of the options and intricacies of ESOPs in a short article because ESOPs have many forms and can be tailored to meet many specific situations and objectives. The key, as with all transition decisions, is to plan ahead so you understand the balance between qualitative and quantitative considerations, know how each is affected by the transition option you are considering, and how each affects your personal planning.

 The most important thing is to plan as much as possible so when the time comes, you are ready.

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Contact your Comerica Relationship Manager or a Comerica Wealth Advisor near you or visit: comerica.com/businesstransition

 

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September 22, 2022
Senior Vice President and National Practice Leader at Comerica Bank

Robert Buchanan, ASA, CFP®

Senior Vice President

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