ESOPs ñ Having Your Cake and Eating It Too

By Tom Taulli

Itís a common story across America. Letís take Jack, a smart and hardworking person, who pursued the entrepreneurial dream and has spent the last 25 years building a thriving business.

He currently takes a salary of $125,000 but, of course, enjoys many perks to avoid paying taxes. Of course, he still loves the excitement of running a thriving business. But he has some things nagging at him: Should I sell? Can I get some liquidity? Should I groom a successor?

No doubt, selling the business will bring liquidity. He may even be able to stay on board as an advisor for the transition. But does Jack really want to be an advisor? In most cases, the answer is no. It is extremely difficult for the entrepreneur to see someone else control his or her business.

The ESOP Solution...

So, is there a compromise position? Actually, there is, and it can be done through an employee stock ownership plan, or ESOP. The ESOP is a well-developed method that has been in existence since the 1950s. Currently, about 11,000 companies have ESOPs, which cover about 8.5 million employees.

The typical structure is a leveraged ESOP. This is geared for C corporations and is based under IRS Code section 1042. Under the law, a company can setup an ESOP to buy shares from an existing owner using borrowed funds. Banks are usually amenable to this, and there may be other sources of capital, such as from institutions, private parties, and even employees.

The shares are placed in a trust on behalf of employees. (Eligibility is usually employees older than 21 who are full time.) Employees will vest ownership in these shares over time, which typically ranges from five to seven years.

Benefits...

Thus, with the ESOP, Jack will be able to get liquidity while also maintaining a critical part of the business.

The company also enjoys tax benefits. For example, not only are the interest payments deductible, but so are the principal payments. This reduces the overall cost of the purchase, which gives comfort to the banks and private lenders.

Of course, an ESOP has a variety of expenses that are unavoidable:
recordkeeping, annual valuations, and so on. But there are many outsourcers who can handle these operations. Keep in mind, though, that the expenses are likely too high for companies with 20 or fewer employees.

Besides liquidity, Jack can reinvest the gross proceeds from the stock sales tax-free--assuming the ESOP trust owns 30% or more of the outstanding shares of the company.

Benefits extend beyond the owner. For example, an ESOP is likely to increase morale in the organization. With employees thinking like owners, they will probably find ways to reduce unnecessary costs, introduce innovation, and jump on profit opportunities.

Conclusion

According to a study from the National Center for Employee Ownership, ESOPs have tended to boost growth 8% to 11% per year. Yes, even in the airline industry, there are successful ESOP plans, such as at Southwest Airlines and JetBlue. It should be no surprise that the motto at Southwest is: "Employees first, customers second, and shareholders third."

An ESOP is not appropriate for all companies. For example, if there is money borrowed to establish the ESOP, a company could be at risk of bankruptcy if payments are not made. Generally, it is a better idea to have a company with strong cash flow as an ESOP candidate.

But an ESOP is something that should be considered for business owners. It provides liquidity; it helps boost employee morale; and keeps the entrepreneur in control. In the corporate world, an ESOP is one of those things that, in many cases, you can honestly call a ìwin-win.î

MergerPlace is pleased to have the esteemed Mr. Tom Taulli as the managing editor of our MergerPlace M & A Advisor™ E-zine.

Tom Taulli is an expert in the M&A process. He is the author of the critically acclaimed The Complete M&A Handbook (Random House) as well as six other books written for publishers such as Bloomberg and McGraw-Hill. Tom also teaches M&A at the USC School of Business.

Tom has been quoted extensively in the press, including the Wall Street Journal, USA Today, Barron's, and The Los Angeles Times, and has provided commentary on CNBC, CNN, and Bloomberg TV, as well as appeared on a variety of top radio stations across the country.

Tom's books are available for purchase in our bookstore.

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