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For many private business owners, figuring out how and when to convert ownership stakes into cash is a growing dilemma. Unlike public companies, private companies lack readily available markets to buy and sell shares and cash out as an owner. This makes liquidity events rare and sometimes hard to navigate for private companies.

At the same time, many Americans are living more active, longer lives—and don’t necessarily want to give up working. Especially among entrepreneurs, work is often a source of purpose, community, and meaningful relationships, all key ingredients for a good life.

That’s why an ESOP is a good tool for business owners who want to separate their retirement from the liquidity event. An ESOP can streamline the path to liquidity, maximize business value, and set up the seller for better succession planning.

By selling some or all of their ownership stakes to an ESOP trust on behalf of employees, private owners can access the liquidity they need, at a fair market valuation that’s often appealing. 

An ESOP buyout doesn’t require a departure, either. Owners can sell in stages and can stay involved in the company as long as they prefer. 

For owners seeking the ideal balance of liquidity, value maximization, employee incentive, and flexible succession planning, an ESOP deserves a closer look.

What is a Liquidity Event?

Before a liquidity event, private company shares are illiquid because no formal marketplace exists to buy and sell them. 

The liquidity event creates the opportunity for shareholders (which can be one or more) to monetize their investment by converting shares into cash or other liquid assets. It’s often a major milestone in a private company’s lifecycle.

A few types of liquidity events include:

  • Initial public offering (IPO) — The company lists on a public stock exchange through an IPO and shares can be bought and sold by investors
  • Merger or acquisition (M&A) — The company is acquired by or merges with another company, and shareholders may receive cash or shares in the new combined company in exchange for their existing shares
  • Secondary sale — Shareholders sell some or all of their shares to outside investors; specialty third-party companies can facilitate these transactions
  • Management buyout (MBO) — Interested members of the existing management team purchase all or most of the company from founders or investors
  • Private equity (PE) investment — Outside private equity firms buy companies that meet their investment strategy objectives
  • Venture capital (VC) acquisition — Venture-backed companies are often acquired thereafter by PE firms or another company in a merger or acquisition
  • Liquidation or dissolution — Selling off company assets and shuttering the company enables remaining cash to be distributed among one or more shareholders

But choosing the most appropriate path to liquidity can be daunting, especially for business owners whose companies hold great personal and professional meaning to them. The choice of path to liquidity can affect much more than the seller’s path to retirement; it can impact the career path of employees, too.

Many paths to sale put the business at risk — of being sliced and diced, replaced, merged, moved, or shuttered. A few, including the ESOP and the management buyout, are a company’s best option for thriving in place. Of these two, the ESOP offers even greater flexibility and control to the selling business owner. 

How An ESOP Creates a Liquidity Event for the Selling Business Owner

How does an ESOP make it possible to create liquidity and separate the sale transaction from the owner's full exit? Here’s how it works:

  1. The business owner establishes an ESOP trust, which purchases some or all of the seller’s shares at fair market value (not more or less, as required by ESOP regulations) using funds from a loan or other financing. This enables the owner to get cash for shares while continuing to lead the business.
  2. By selling in stages to the ESOP over time, and by taking on some of the financing through notes, the seller can create a highly customized, gradual path to liquidity, if that’s what they prefer. It’s possible to sell a minority stake and maintain corporate control, but tax benefits differ. 

A 100% ESOP-owned S corporation is not subject to federal or state income tax.

  1. Along with control over the liquidity path, the seller also gets the flexibility and control to stay on as a leadership employee, and to stay involved in the company. Whether it’s a transitional period or long-term, the seller’s exit is determined by choice. Their hand’s not forced by the sale.
  2. Many selling business owners stay on in an advisory or board role, even after retirement.

Potential Future Liquidity Events for Employee-Owners, Too?

The selling business owner is able to cash out in an event, and employees gain ownership gradually.

The ESOP makes employees beneficial owners. The ESOP trust is the legal owner of the corporation; it owns shares on behalf of employees. The ESOP allocates shares to employees over time according to the plan’s vesting schedule. 

When fully vested employees retire, they receive a distribution based on fair market value of the shares in their ESOP accounts, which can be rolled over to a retirement account to maintain tax-deferred status on the ESOP retirement account. Over the course of a career, that can add up to a significant amount—without employees making a contribution.

A Path to Liquidity and Much More

Each business owner’s decisions about when and how to convert their ownership stakes into liquidity can be complex, and sellers have a lot of options to consider. Private equity or M&A offers can deliver quick liquidity — in exchange for a loss of control over their departure, and with no guarantees you’ll get fair market value. It’s easy to understand why so many business owners put off selling.

Start building a vision for your company’s future that extends beyond the ownership transition. Find out how an ESOP impacts company culture, performance, and employee retention, and learn what it takes to comply with regulatory requirements. Download our free guide, What to Expect After the Transition to an ESOP Company. Click below to get yours now.

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