ESOP Pros and Cons: Overcoming 9 Common Misconceptions

Posted by Aaron Juckett, CPA, CPC, QPA, QKA on Tue, Jul 06, 2021
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In the course of investigating exit strategies, business owners often look for a straightforward comparison of the different ways to sell a company.

Unfortunately, side-by-side comparisons are hard to come by. And, when you find them, they’re often oversimplified and even inaccurate. Besides, every business is different, and so are the needs of every seller. You may not get the answers you need.

Owners also often look to trusted advisors — attorneys, accountants, financial advisors, and other specialists — when the need to sell the business appears on the horizon. 

While it’s smart to look to experts, keep in mind that not all professionals have experience with ESOPs. That lack of experience may influence their recommendations.

Plenty of sources list ESOP advantages and disadvantages and explain structures, timelines, costs, and more. But are the cons on these lists truly downsides, or do they point to a need for more information?

More often than not, the “cons” on these lists point to a need for an experienced ESOP advisor to guide you through the steps of an ESOP sale and transition. Read on to review some of the most commonly cited ESOP “downsides,” and get an understanding of the bigger picture behind these common misconceptions.

1. An ESOP is too complicated and time-consuming.
2. An ESOP is too expensive.
3. An ESOP is only for C corporations or S corporations.
4. An ESOP can’t get you more than fair market value.
5. ESOPs aren’t for small businesses or startups.
6. An ESOP sale’s negative impact on a business’s balance sheet can create problems with lenders.
7. An ESOP sale puts the business owner (seller) at risk.
8. Future repurchase obligations can affect cash flow and require significant advance planning.
9. An ESOP’s planning, preparation, oversight, and administration aren’t worth it.

 

1. An ESOP is too complicated and time-consuming.

When a legal or financial professional tells you an ESOP is too complicated, one thing is certain: The advice is not coming from someone with significant ESOP experience.

Think about how many complicated subject areas you deal with in life: taxes, IT, real estate, and a lot more. Anything outside your own expertise might seem complicated to you. So what do you do when you need a solution in any area that seems too complex for your comfort? You seek the advice of an experienced professional to make sure you get all the details right, and plan ahead to avoid unnecessary obstacles or complications. On average, an ESOP sale takes about 120 days to complete. Compared with sometimes years-long timelines of third-party sales, or the complex negotiations of mergers and acquisitions, an ESOP offers a manageable and even predictable timeline.

Bottom line: Yes, an ESOP transaction can be complex, and ongoing management can require professional services. But you don’t let that get in the way of installing an HVAC system or using computers. Don’t let complexity take an ESOP off the table.

 

2. An ESOP is too expensive.

It’s true that costs are associated with an ESOP transaction. But if an ESOP is right for your business, your annual tax savings and company cash flow savings will be greater than annual ESOP expenses. Over time, the sale of the company to the ESOP is paid for by those savings.

Now, is this true across the board for every business? No. If your profitability and current tax situation point to annual tax and cash flow savings that would not offset the ESOP cost, a scrupulous ESOP advisor will make that clear and suggest other alternatives for your exit strategy.

Bottom line: If an ESOP is right for you, you’ll see that the costs are worth the outcome.

 

3. An ESOP is only for C corporations or S corporations, not partnerships or other types of corporations.

If employee stock ownership is a good fit for your company, it can be worth the relatively simple process of converting your business to an S corporation or a C corporation as part of your transition process to an ESOP. Selling a C corporation to an ESOP enables a business owner to defer or avoid taxation on the sale proceeds. Some business owners opt to sell to an ESOP while a C corporation, and then convert to an S corporation after the ESOP sale.

Bottom line: If your company is otherwise a good match for an ESOP, a trusted ESOP advisor can guide you through the process of converting your corporation.

 

4. An ESOP can’t get you more than fair market value.

Sure, maybe a third party can offer a strategic premium at sale — but at what cost to you, your tax bills, and especially your employees down the line?

By law, an ESOP sale is required to pay fair market value for the business. But there’s more to consider than the sale price. Because of capital gains tax rates, to actually receive more in total proceeds after taxes, that third-party offer may need to be much higher than you expect.

In addition, third-party sales can be unpredictable and drawn-out; negotiations can lead to unattractive conditions for the seller. Nor can a third-party sale offer the same control over time horizons and succession planning that an ESOP sale can.

Bottom line: If you want to compare options and calculate how an ESOP sale and a potential third-party sale might compare for your business, contact ESOP Partners to request a feasibility analysis.

 

5. ESOPs aren’t for small businesses or startups.

Your business might not yet be mature enough for an ESOP sale, but that should not stop you from investigating the opportunity. Remember, most business sales take place over a longer-term timeline. In addition, a truly expert ESOP advisor can help you evaluate the feasibility of a Growth ESOP or pay-as-you-go structure, both of which create a path toward employee stock ownership that a business can follow over time.

Bottom line: ESOPs aren’t the right fit for every business, but before you dismiss the opportunity, get the advice of an expert.

RELATED: ESOP Success Stories Highlight Advantages of Employee Ownership

 

6. An ESOP sale’s negative impact on a business’s balance sheet can create problems with lenders.

An ESOP transaction creates negative equity, and that impacts a company’s balance sheet and debt ratios. But experienced lenders — and even your regular commercial lender, if they’re willing to learn — will understand that by and large, ESOPs are healthy, thriving businesses they should want to lend to. A study of ESOP loans between 2009 and 2013 found an annual default rate of just 0.2%. 

Bottom line: An expert advisor can help you through the conversations needed to educate your lender — or help point you toward lenders that understand the ESOP opportunity.

 

7. An ESOP sale puts the business owner (seller) at risk.

Every business owner acknowledges a certain level of risk; that’s part of entrepreneurship. But a seller to an ESOP relies on several factors for the transaction to be successful to them. ESOPs are designed to ensure a fair price for the business — but the business’s continued success is also vital. And, the ESOP’s debt to the seller is subordinate to any line of credit and bank debt. That’s why the owner’s control over succession planning, incremental sales, and other structural options should all be part of the planning process.

Bottom line: Any business exit strategy carries with it some risk to the seller, just as not selling has its own inherent risks. As an owner, you should want to understand all your options before selling your business.

 

8. Future repurchase obligations can affect cash flow and require significant advance planning.

Is the need for planning really a downside? Business owners come to terms every day with the many costs of doing business: structural, regulatory, legal, financial, and more. Repurchase obligations are subject to regular forecast updates and reviews, and become part of the long-term strategic business planning process for any ESOP company. In time, your ESOP repurchase obligations become fully integrated into the business plan.

Bottom line: An ESOP is a uniquely structured business and a qualified retirement plan. Employee stock repurchase obligations are an essential part of every ESOP.

 

9. An ESOP’s planning, preparation, oversight, and administration aren’t worth it.

If you’re just starting to evaluate your exit strategy options, a third-party sale, acquisition, or other option may seem simple and appealing. While a business broker may tell you the average time to sell a business is 9 months, no business is an average business. Negotiations on price, terms, conditions, ongoing seller involvement, employee status, and more can complicate and extend timelines, and there’s no guarantee that the sale price will reflect fair market value.

 

Bottom Line: Important Decisions Deserve Attention to Detail

Does an ESOP sale take planning, oversight, and steps to ensure regulatory compliance? Absolutely. Does the ongoing success of an ESOP company require preparation, succession planning, and the advice of an expert? Typically, yes.

But the benefits of selling your company to an ESOP often far outweigh the learning curve of the transition. Some benefits to the seller include:

  • Full payment at fair market value
  • Potential 10–12% rate of return on investment when seller-financed
  • Section 1042 sale can enable an owner to defer or avoid taxation on sale proceeds
  • The owner can sell and still retain control of the company
  • Provides liquidity and diversification to seller
  • And more

It’s rare, if not impossible, to match these important advantages with other exit strategies.

If you’re ready to explore whether your business is a good fit for an ESOP sale, review our tip sheet, Is An ESOP Right for Your Company? It offers an overview of business transition alternatives, and explains some of the most important characteristics that strong ESOP candidates have in common. Request yours now by clicking the link below.

HmPg-CTA-Right for Your Company

Topics: Business Exit Strategy, ESOP Planning, Business Succession Planning

Aaron Juckett, CPA, CPC, QPA, QKA
Written by Aaron Juckett, CPA, CPC, QPA, QKA

Aaron is President and Founder of ESOP Partners and provides implementation, administration, and consulting services to hundreds of companies. He is a member of The ESOP Association (TEA) and the National Center for Employee Ownership (NCEO).

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