When owners of privately held companies explore their options for an ownership transition and liquidity opportunity, plenty of questions can arise — especially when it comes to future business growth and sustainability.
If your team is evaluating the potential advantages of selling to an employee stock ownership plan (ESOP), the financial implications are likely at the forefront of the discussion.
Financial leaders, especially CFOs, often bear the responsibility of assessing and managing financial risks associated with major business decisions. And if you’re not as familiar with ESOPs as you might be with mergers and acquisitions, for example, you may find yourself navigating a landscape of myths, misconceptions, and misinformation.
An ESOP can offer a path that not only addresses the immediate financial concerns of the selling business owner, but also paves the way for a sustainable financial future that’s good for employees’ financial security in retirement, too.
In this article, we demystify the financial dimensions of ESOP transitions and ongoing administration. We answer common questions and provide a clear picture of how ESOPs can serve as a robust strategy for an ownership transition—and from there, promote a culture of employee engagement and financial growth.
We’re confident that once you tackle your biggest finance-related questions head-on, you’ll want to learn more about the financial advantages an ESOP can bring to your organization.
1. Aren’t ESOPs Expensive to Establish and Administer?
The misconception here is that the consulting, valuation, and administrative costs are prohibitive. Yet 5,887 closely held or private corporations have ESOPs. While most new ESOPs are 100% owners, even more existing ESOP companies are partially (not 100%) owned by the ESOP trust. This shows that even those minority-held ESOP companies find the plan’s ROI justifies their ESOP-related expenses.
At the same time, ESOPs pay wages equal to or higher than market averages, and often better benefits, as well. This is all evidence to suggest that an ESOP’s advantages can (and very often do) outweigh the costs.
By and large, ESOP-owned companies outperform their non-ESOP peers. They weather shocks (like recessions and pandemics) better. They experience lower levels of employee turnover, a costly problem for many businesses today.
And of course, a 100% ESOP-owned S corporation is not subject to federal income tax. That advantage deserves close attention — because the ESOP tax benefit, over time, can significantly offset costs associated with the ESOP sale and ongoing administration. Of course, every organization’s financials are unique, and that’s why we recommend a no-cost readiness assessment to explore whether it’s a good fit for your objectives.
Ultimately, it’s important to remember that every ownership transition strategy comes at a cost—and not all exit strategies have the same potential as an ESOP to support long-term business growth.
2. Won’t the ESOP Negatively Impact Our Company’s Valuation?
There’s a common misconception that in the process of establishing an ESOP, the company’s valuation could suffer.
ESOP company valuations depend on expectations for future cash flow and evidence that the company can satisfy its obligations to lenders and repurchase obligations. In other words, ESOP company value is driven by performance — and ESOPs generally perform better than their non-employee-owned peers.
Experts point to plenty of reasons why this is often the case. When employees are motivated by annual share value increases, it can support a virtuous cycle of growth and increasing value. It’s also true that people are often more careful with things they own, and ESOP employees often see their work in the context of supporting profitability. Shared attention to the bottom line is usually good for business.
If the bottom line is a top concern, it’s important to consider all the details that can impact a sellers’ net proceeds. Many businesses discover the overall cost of selling to an ESOP to be lower than expected — and there’s no business broker’s commission or success fee, which can take a big bite out of sale proceeds. Altogether, that difference, plus the personal tax advantages and flexibility in structuring the sale, explain why net proceeds from an ESOP sale can often compete with third-party sales (in the absence of synergistic premiums).
3. If Employees Become Owners, Who’s In Control?
Stakeholders who are unfamiliar with ESOPs may confuse beneficial ownership with controlling stakes. But an ESOP is required by law to engage an ESOP trustee who serves as a fiduciary providing oversight in the best interests of employee-owners. Becoming an ESOP doesn’t mean giving employees voting rights over key business decisions.
Rather, an ESOP enables the selling business owner to separate the liquidity event from their exit. That means they can maintain their operational leadership position all the way to the end of their careful succession plan — and that can take anywhere from weeks to decades.
4. Aren’t ESOPs Overly Complex and Risky?
Complexity is a commonly cited concern. That’s easy to understand, since an ESOP isn’t just an exit strategy; it’s also a qualified retirement plan subject to regulation by the Internal Revenue Service and Department of Labor under the Employee Retirement Income Security Act of 1974 (ERISA). That means there are required documents, regular filings, and rules that must be strictly followed.
But the same could be said of virtually any other means of transitioning business ownership. A third-party sale may involve broker fees, myriad legal and financial documents, valuation and appraisal, contracts, corporate resolutions, non-compete agreements, contingencies, and much more. Transactions can come down to the wire or collapse before completion. And finally, third-party sales miss out on significant ESOP tax advantages — lowering net value to the seller in the big picture.
In general, business transactions are often complex and involve a certain level of risk. But working closely with a trusted team of ESOP experts enables your team to address and mitigate ESOP risks, so you can move forward with clarity and confidence.
5. Will Employees Understand What It Means to Be Shareholders?
It’s fair to expect to educate employees on what employee ownership means. In our experience, ESOP companies that communicate clearly with employees and cultivate an ownership culture reap substantial rewards.
Lower turnover, higher satisfaction, and stronger engagement are common when employees understand the ESOP structure and see value grow over time. With proper education and communication, employees become passionate advocates for the company’s success.
6. Will the ESOP Have to Share Sensitive Financials With Employee Owners?
ESOP leaders often follow open-book management practices, but that doesn’t mean literally opening the books. Confidential or sensitive information can and should remain protected. Employees don’t need access to details like salaries, contracts, and financial details. But sharing high-level performance metrics, operating ratios, department budgets, and tracking toward goals can help employees understand how their work contributes to the bottom line. The right level of financial transparency and education empowers employees to think and act like owners.
7. Is it Less Risky to Sell to a Third-Party Buyer for Cash?
A third-party sale may seem simpler on the surface. But considerable risks remain: deals falling through, buyers changing terms, and business disruptions during due diligence. And a third-party buyer may quickly move to cut costs, trim staff, and compromise company culture after the sale.
With an ESOP, the owner can retain control through a gradual transition. And employees are incentivized to help grow the business. ESOP transitions, like all business transitions, do involve risk. That’s why working with experienced advisors is key. But for many owners, the ESOP path is ultimately less risky than other exit strategies.
Proceeds from a third-party sale are typically taxed at ordinary income and capital gains rates, while ESOP transactions are taxed at lower capital gains rates. In some cases, the seller can choose to defer taxation—sometimes indefinitely.
8. Might It Be Smarter to Wait and Sell Later?
Some owners or financial leaders argue it’s better to hold off on an ownership transition in the hope of getting a better price down the road. But in recent years we’ve seen how quickly economic conditions can change. Timing the market is tricky, and owners may risk missing their window of opportunity.
With an ESOP, the selling business owner stands to potentially benefit from future growth instead of leaving those gains on the table. Flexibility in structuring the transaction can help optimize net outcomes, too. And of course, the tax advantages make selling to an ESOP more attractive than waiting to sell to a theoretical outside buyer.
9. How Will an ESOP Loan Impact Operations?
An ESOP company’s balance sheet typically reflects increased liability and reduced equity, and contributions to the ESOP to service the loan—and to meet future stock repurchase obligations—have an impact on cash flow. So, managing an ESOP certainly requires prudent planning and cash flow management.
But an ESOP’s tax advantages help offset the costs of debt repayment and future ESOP distributions. When financial leadership is aware of all the implications, and working closely with trusted experts, obligations don’t have to limit company growth or sustainability.
If you’re concerned your trusted business lender may hesitate to finance an ESOP, reach out for expert help. In our experience, once lenders have a chance to dig in and understand how the tax advantages support sustained cash flow, they’re happy to do business with ESOPs.
Got More Questions? Get Answers From the Experts
An ESOP can be a powerful strategy for business owners seeking a profitable exit that also sustains their legacy and engages employees. And like any major transition, an ESOP requires thoughtful planning to manage financial risks and achieve company growth objectives. But an ESOP’s benefits typically outweigh the costs.
As a financial leader to your organization, you have an obligation to seek clarity and financial transparency. Take the next step by exploring the many business advantages of an ESOP. Download our guide, Key Benefits of Incorporating an ESOP in Your Business Exit Strategy. Click below to discover why, with proper planning and trusted advisors, an ESOP can pave the way to a successful future for your company and employees.