Employee stock ownership plan can serve as exit tactic

As they near retirement age, many entrepreneurs are considering selling the businesses they built. When considering their exit strategies, they face difficult decisions for monetizing their businesses’ enterprise value. Although owners want to receive “fair market” value for their businesses, they may not want to sell to a third party (a strategic buyer or a private equity firm).

The owner may want to reward loyal employees who have significantly contributed to the business’s successes. If the owner is willing to receive fair market value versus strategic market value an employee stock ownership plan may be a practical exit strategy.

What is an employee stock ownership plan?

Employee stock ownership plans are qualified retirement plan similar to a profit-sharing plan with one main difference. An employee stock ownership plan is required by statute to invest primarily in shares of stock of the plan’s sponsor (the corporation selling the stock). Unlike other qualified retirement plans, these plans are specifically permitted to finance the purchase of employer stock by borrowing from the corporation, other lending sources or from the shareholders selling their stock.

When Congress authorized employee stock ownership plans in 1957 and defined their rules in 1974, it had two primary goals:

(1) To provide tax incentives as a vehicle for owners of privately held companies to sell their companies;

(2) To provide ownership opportunities and retirement assets for working-class Americans.

How does an employee stock ownership plan work?

First, the corporation’s board of directors adopts an employee stock ownership plan and trust and appoints an independent plan trustee. Then the corporation’s equity is appraised.

The trustee negotiates the purchase of all or some of the corporation’s issued and outstanding stock from one or more selling shareholders. The corporation may borrow money for a portion of the shares from an outside lender and loan the proceeds to the plan so it can purchase the shares. (Rarely does the corporation have enough cash on its balance sheet to loan to the plan; hence the corporation typically will borrow from an outside lender).

If only a portion of the shares is funded with senior financing, the remaining shares often will be purchased through subordinated promissory notes given to the selling shareholders. They will receive an interest rate appropriate for subordinated debt.

The corporation is required to make tax-deductible contributions to the employee stock ownership plan each year, similar to contributions to a profit-sharing plan. The trustee uses the funds to make payments to repay the outstanding loans. In addition to the mandatory contributions, the corporation can declare and issue tax-deductible dividends (C corporation) or earnings distributions (S corporation) on shares of the corporation’s stock held by the plan. Often the trustee will use these dividends/distributions, too, to pay down the plan’s loans.

Tax benefits of an employee stock ownership plan exit strategy accrue to the selling shareholders, the corporation and the employees who participate in the plan. The tax benefits to the selling shareholder and corporation vary depending on whether the corporation is taxed as an S corporation or as a C corporation.

Nontax advantages

The advantages of an employee stock ownership plan exit strategy are many. They include:

▶ A ready-made market for the owner’s stock;

▶ A ready-made buyer for the owner’s business;

▶ A lower marketability discount (typically 5 to 10 percent) when valuing shares on a “fair market value basis” vs. a “strategic market value basis”, since the employee stock ownership plan is the market for those shares;

▶ A business owner who can gradually transition the ownership over a period of time and thus remain actively involved in the business;

▶ A vehicle for the owner to receive the desired liquidity without selling to a competitor or other third parties;

▶ A retirement benefit for employees;

▶ Avoidance of integration plans and associated costs to restructure operations, reorganize management or reduce staff because management and staff continue in place after the transaction closes;

▶ Avoidance of giving out confidential information to a competitor or other potential buyers;

▶ A long-term financial investor (the plan) that will not seek to sell the corporation in a relatively short time.

Some disadvantages

Like most business decisions, there are trade-offs to any exit strategy.

It is important to remember that an employee stock ownership plan is a qualified retirement plan governed not only by the Internal Revenue Code, but also by the fiduciary and disclosure rules of the Employee Retirement Income Security Act. High fiduciary duty standards must be met.

This adds additional costs to the corporation including the cost of:

(1) Retaining an independent trustee, an independent financial advisor and independent legal counsel to advise the ESOP trustee;

(2) Engaging qualified employee stock ownership plan counsel experienced with employee stock ownership plan stock purchase transactions in addition to corporate counsel;

(3) Ongoing administrative, fiduciary and legal expenses associated with an employee stock ownership plan that might not be present in a sale to a third party;

(4) Maintaining the plan and trust documents, a recordkeeper/third-party administrator, a trustee and annual valuations of the share value of the plan;

(5) Calculating amounts of tax-deductible contributions made to the plan each year;

(6) Monitoring who can participate in the plan depending on the Code section 1042 election, even if they are employees of the corporation;

(7) Implementing anti-abuse provision, Section 409(p), which restricts any one participant or family from receiving excessive share allocations in the plan or other synthetic equity issued by the corporation;

(8) Obligating the corporation to have a stock repurchase plan; this requirement must be monitored and funded on an ongoing basis for participants eligible to receive a distribution of their employee stock ownership plan stock accounts as they retire or terminate employment. The corporation is then required to repurchase the stock at the current fair market value.

Employee stock ownership plans are technical and complex. If business owners are considering them as an exit strategy, they should plan carefully with a wealth management firm, a qualified employee stock ownership plan tax adviser and a qualified employee stock ownership plan transaction law firm.

Gary Miller is the managing director, consulting division, SDR Ventures Inc. in Denver. SDR, an investment banking firm, provides “buy-side”, “sell-side”, private capital formation and business consulting advisory services for middle market business owners of privately held companies. Reach him at 720-221-9220 or

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