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ESOPs as a Flexible Ownership Transition Tool

When it comes to succession planning, business owners have multiple options, each carrying different benefits and implications. How do you decide the best path for you and your business? Start by asking yourself what personal and business objectives you want to achieve through your exit strategy. You may decide that you have multiple objectives and need a flexible transition vehicle to achieve them all.

Employee stock ownership plans (ESOPs) are a flexible ownership transition tool that can allow a business owner to accomplish objectives unmet by other alternatives. An ESOP is a tax-qualified retirement plan that enables a business owner to sell all or a portion of his or her ownership interest to a special purpose trust for the benefit of participating employees. Because of their built-in flexibility, ESOPs can be an optimal ownership transition vehicle, enabling an owner to sell in full or in stages, achieve communitarian objectives such as preserving the company’s culture and/or protecting community employment, and remain active in the business if desired. Substantial tax benefits augment these benefits.

Selling Minority or Majority – The Choice is Yours

The outright sale of a business is not always desirable or optimal. With an ESOP, an owner may sell all of his or her ownership interests to an ESOP in a one-time transaction or choose to sell in stages over time. This flexibility helps when there are multiple owners of a business. An ESOP can be particularly useful when some owners wish to liquidate and exit the business while others are interested in continuing their ownership and involvement. Once the ESOP is in place, it serves as a ready buyer when the remaining shareholders are ready to sell. An ESOP also can be used as an early succession planning tool to provide liquidity and diversify net worth over time because ESOPs can purchase anywhere from one to 100% of a company’s stock.

Finding a Buyer – Hard to Market Businesses

Not all businesses lend themselves to a sale to a strategic or financial buyer, whether due to business structure or industry sector. There may be difficulty in finding a market for a business. If this is the case, an ESOP can be a viable option. There are successful ESOP-owned businesses across a wide range of industries. There are, however, size considerations due to the cost and ongoing administrative requirements. Note that an ESOP cannot pay more than fair market value for a company's shares as appraised by an independent valuation firm.

Protecting Your Community and Your Life’s Work

An owner typically develops a strong feeling of identity with the company and often has a sense of loyalty to the employees who helped build and grow the company. If legacy is important to an owner, a sale to a third party might not be the best option. One solution is to transfer ownership of the company to a family member or company management. Although an owner may prefer to sell to an insider, most employees and family members do not have the financial wherewithal to buy out the business owner.

An ESOP can be a means to accomplish these goals. ESOPs minimize business disruption and enable a company to retain employment in a community while rewarding its employees. With a sale to an ESOP, employees do not use their own funds to buy the company. The company typically borrows money from lender(s) and/or the selling shareholder(s) and, in turn, loans the funds to the ESOP trust to acquire the shares.

Maintaining Company Culture

Ownership transition strategies involving an outside party can result in a substantial change to company culture. Selling to an ESOP ensures company culture remains intact. In fact, as owners' and employees' interests increase in alignment, employee ownership can often build an even stronger culture and enhance the company’s operating performance. 

These benefits tend to continue over time, as employees have a vested interest in the company's overall health. ESOPs can also be valuable in attracting and retaining sought after employees. Creating a workplace culture that instills a sense of ownership can lead to increased employee engagement, lower turnover, and a commitment to preserve employee jobs whenever possible.

Remaining Involved

Oftentimes, a business owner wants to begin the ownership transition process but remain actively involved in the business. ESOPs provide such flexibility. Selling a company to employees provides both liquidity and investment risk diversification without resulting in a leadership change. While a sale to a competitor or private equity firm likewise generates liquidity, a selling shareholder can seldom continue in a leadership role as his or her involvement is typically limited after the sale.

In addition to an owner’s continued involvement, a company’s management team typically remains in place after an ESOP transaction and continues to drive the business. Selling shareholders often feel more confident about their business's future with a strong management team remaining in place. The continuity in leadership allows for a smoother transition.

In Conclusion

One of the greatest advantages an ESOP offers is its flexibility. Selling to an ESOP allows an owner to generate liquidity, diversify his or her net worth, and implement a succession plan while continuing to run the business and preserve the owner’s legacy. The best way to evaluate if an ESOP might meet your needs as a business owner is to discuss your goals and objectives with a knowledgeable and experienced ESOP professional. Contact a member of First Midwest Bank’s ESOP Finance Group to learn more.

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