Considerations for Selling to an ESOP

An employee stock ownership plan (ESOP) is an employee benefit plan that allows employees to share in the ownership of the company they work for. The shares are held in a trust, established by the company, for the benefit of participating employees. Generally, a company forms an ESOP which then purchases stock from the existing owner(s) at fair market value. The ESOP can finance the purchase in a number of ways, generally through some combination of cash contributions from the company, selling owner financing, and bank financing. Repayment on any financing is generally made using cash contributed by the company and distributions or dividends on the stock the ESOP has purchased.  

After the purchase, the ESOP holds the company stock in trust and allocates it to employee accounts over time in accordance with its plan documents and applicable law. For most ESOPs, the Company is required to repurchase ESOP shares allocated to retiring and terminated employees at fair market value, with some options for purchase and payment timing. The proceeds of these redemptions are generally rolled over by the former employee into an IRA or other qualified retirement account. As the company grows, the employees share in that increase in value.   

Business owners considering selling to an ESOP should review the advantages and disadvantages of an ESOP. 

Advantages: 

  • Sellers have an avenue for exiting the business or receiving a return on their original investment without searching for a third-party buyer. 
  • Non-recourse ESOP financing is available. 
  • ESOPs increase the likelihood that the business will remain in the community where its employees live and work.  
  • Tax benefits exist for selling to an ESOP, including potential gain exclusion in some states and potential deferral of capital gains under Internal Revenue Code Section 1042.   
  • Tax benefits to the company.  
  • Deductible ESOP contributions. 
  • Deductible principal and interest payments. 
  • Tax-free earnings – some ESOPS do not pay federal income tax. 
  • Smooth transition with minimal changes to corporate culture. 
  • Helps ensure continuity of leadership while maintaining the legacy of a business 
  • Does not have to be an end-all-be-all transaction – common next steps are secondary ESOP sales and share buybacks. 

Disadvantages:  

  • ESOPs cannot offer more than fair market value, often meaning a lower price than could be paid by a strategic buyer.    
  • Selling shareholders often need to provide partial financing to make the transaction work.  
  • Less liquidity/cash at closing.  
  • Initial and ongoing administrative requirements 
  • Subject to Employee Retirement Income Security Act (ERISA) and ongoing regulations. 
  • Requires appointment of a trustee to act as a fiduciary of the ESOP, performance of annual valuations of the ESOP-owned stock, a third-party administrator to help maintain participant accounts, & lawyers to represent various parties. 

There is no magic way of knowing whether an ESOP could work for you. However, an ESOP might be worth considering if the company: 

  • Has at least thirty employees who are qualified to participate in the ESOP and annual revenues of at least $5 to $10 million. 
  • Has relatively stable profits and value from year-to-year. 
  • Is not highly leveraged and has a good relationship with its lender.  
  • Can cover the costs of initial setup and maintenance. 
  • Has a strong management team. 
  • Has a low employee turnover rate – employee continuity is important for a successful ESOP. 

How BrownWinick Can Help 

If you are a business owner considering setting up an ESOP for your company, BrownWinick can help. Our attorneys have experience assisting in nearly all stages of setting up an ESOP, including structuring transactions, plan formation, negotiating financing terms and structure, tax planning, collaborating with other advisors, experts, and independent trustees, setting up governance, and all the issues that come up in any sale transaction. We design and draft qualified ESOP plans, negotiate ESOP sale transactions, and aid with ongoing compliance and administration of an ESOP. 

Give us a call to discuss your situation and whether an ESOP might be right for you, your business, and your employees.  

Special thanks to Summer Associate Sarah Herz for her assistance in the writing and research of this blog.