Holding companies are created to meet a variety of business needs, particularly for the owner of multiple businesses. When it comes to the world of employee ownership, the same can certainly be said about holding companies owned by employee stock ownership plans.
An ESOP-owned company may opt to become a holding company for several reasons, including:
- Pursuing a strategy of diversification through acquisition
- Enhancing shareholder value through consolidation
- Enabling innovation via vertical integration within an industry
- Distributing liabilities across multiple entities
- Expanding employee ownership to workers at small companies
- Tapping into efficiencies of scale
- Establishing their own shared services companies
Successful ESOP-owned companies that achieve a strong cash position can make excellent acquiring buyers of other companies. When they do, choices need to be made about how to execute the ownership change.
For the right combination of diverse businesses and ESOP leadership, an ESOP-owned holding company can be a great idea. But just as every holding company is unique, so is every ESOP — and combining two complex business concepts calls for rigorous due diligence and consultations with experts.
In this article, we’ll take a closer look at ESOP holding companies. Here are a few key points to consider.
What is a Holding Company?
A holding company, as the name suggests, is a parent business entity that holds controlling stock (51% to 100% ownership) in operating companies and/or subsidiaries. The companies it owns can be in related industries, or in completely disparate fields.
Potential Advantages of an ESOP-Owned Holding Company
So let’s start with an in-depth look at some of those key reasons for establishing an ESOP holding company to control multiple businesses.
- Diversification Through Acquisition
- Enhancing Shareholder Value
- Mitigating Risk
- Expanding Employee Ownership to Workers at Small Companies
- ESOP Tax Advantages Help Foster Growth
Diversification Through Acquisition
Done right, acquisitions can help diversify a company’s customer or client base, expand into new geographical markets or industries, and achieve greater efficiency by occupying more of a vertical market.
That diversification can also lead to process improvements and innovations that otherwise might not happen, since multiple companies within a holding company may have greater opportunities for cross-pollination of ideas.
In addition to these potential advantages, the ESOP holding company may also create shared services companies to streamline administrative processes and reduce costs across the portfolio of companies. Those shared services subsidiaries help optimize financial control and reduce costs, potentially improving the overall bottom line.
How an ESOP Maximizes Value When You Sell Your Business
Unlike a third-party sale, an ESOP transaction can net up to 90-110% of your company sale price. Learn more in our free eBook.
Enhancing Shareholder Value
Consolidating multiple companies within a holding company can have the potential to help strengthen the overall health of the ESOP-owned business entity. The company’s value is what determines the retirement benefit value to ESOP plan participants.
That’s why it’s not an unreasonable strategy to acquire additional good-value businesses, integrate them into an ownership culture, optimize for efficiency and productivity, minimize waste and harness innovation across the portfolio of companies.
While potential for value can increase when companies are brought together under holding company management, risk can actually be mitigated quite effectively. When established correctly, subsidiary companies’ debts remain with each subsidiary, rather than becoming the debt of the holding company. So creating a holding company can help separate assets and liabilities to shield the holding company and protect other subsidiaries against risk.
Expanding Employee Ownership to Workers at Small Companies
An ESOP-owned holding company can create opportunities for smaller business entities, through acquisition, to become part of the ESOP, even while maintaining their distinct cultures. This can help each smaller company continue to serve its customer base in ways that build and bolster its success, while attracting and retaining great employees with a valuable retirement benefit that may have been out of reach if it weren’t for the holding company option.
ESOP Tax Advantages Help Foster Growth
Holding company or not, an ESOP’s tax treatment can create a cash flow advantage over the long term that can support investments that can further grow the business. In this way ESOP plan participants can benefit from shared ownership in the holding company’s growing business empire.
How Do ESOP-Owned Holding Companies Start?
ESOP companies often pursue acquisitions to grow their core business, expand into related markets, or diversify their business more broadly. This is typically accomplished in one of two ways:
- A business that is being sold to an ESOP may be set up as a holding company with affiliates and subsidiaries from the start; or
- An ESOP company in a strong cash position can reorganize as a holding company to streamline an acquisition strategy
What to Consider Before Creating an ESOP Holding Company
The advantages of an ESOP and of a holding company are distinct and can certainly be mutually beneficial, but it’s also important to understand that combining two complex business strategies can generate new, ESOP-holding-company-specific complexities.
For example, ESOPs are subject to specific accounting standards and regulatory requirements. Because an ESOP is a qualified retirement plan, it’s subject to the Employee Retirement Income Security Act of 1974 (ERISA). That means specific recordkeeping, reporting, and filing requirements with the Department of Labor and the Internal Revenue Service.
The complexities of a holding company structure with all its subsidiaries and/or operating companies can add significant effort and cost to administrative requirements like annual valuations. The nature of a holding company can also complicate the process of establishing and nurturing a cohesive ownership culture.
ESOP fiduciary rules can certainly complicate the process of documenting due diligence and decision-making in any process of acquiring or establishing new entities — since business decisions must be evaluated for their potential impact on share value.
At the same time, holding companies can reduce costs by pooling insurance, sharing third-party administration services, etc.
If You’re a Business Owner Thinking About Selling to an ESOP Holding Company
Whether you’re involved in a larger group of small companies with shared affinities or an established ESOP company with a strong cash position, you may be thinking about the potential advantages of either establishing an ESOP holding company or selling to one
For the current owner of a closely held company who’s considering selling, an ESOP holding company can create an opportunity to access the liquidity from the sale and remain in a leadership role for the time being, helping to manage the change to an employee ownership culture and controlling the nature and pace of their exit.
Knowing, too, that an ESOP trustee’s fiduciary duties require them to act in the best interest of employee owners, means that being acquired by an ESOP company offers at least the assurance of a fiscally responsible buyer who’s actively managing for cash flow. For the seller who cares about their employees’ future wellbeing, an ESOP holding company — rather than, say, a vulture capitalist — can offer some peace of mind.
At the same time, it’s certainly worthwhile to investigate the possibility of establishing an ESOP company rather than selling to a holding company, especially if legacy and a controlled exit are important factors to the selling shareholder.
And it’s of the utmost importance to understand how ESOP requirements may impact holding company management decisions. Consulting with your business legal counsel is always a vital first step — and if their familiarity with employee stock ownership plans is limited, it’s smart to bring in the experts for an early conversation.
An experienced ESOP consultant can help model potential financial consequences of your options and ensure you’re aware of the most important aspects of the decision.