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Employee buyouts, frequently in the form of an Employee Share Ownership Plan (ESOP) are gathering popularity as the benefits for the owner/seller, the employees/buyers and even the community as a whole become recognized and governments move to simplify legislation around the transaction and attach tax incentives to this type of transfer.
Historically, ESOP arrangements were introduced to achieve a number of business improvement related goals.
More recently, dealing with the consequences of business closure upon the retirement of their owners has become a major public policy issue and programs have been set up to assist owners sell their business to their employees or to local community groups in an effort to preserve community infrastructure and jobs.
As an exit strategy an ESOP is a way of achieving transfer from the current owner to the employees by selling them all shares, or at least a controlling stake, in the business.
Different schemes provide for this to take place over a longer or shorter term. The mechanism to achieve buyout most quickly is the leveraged (or geared) ESOP where sufficient funds are borrowed from an external lender to buy out the current shareholder(s).
In its most basic form an ESOP transaction involves only four steps:
- The financer makes a loan to the company. Usually this loan is made with an agreement that the company will make a ‘mirror loan’ to the ESOP.
- The company makes a mirror loan to the ESOP. Since the ESOP has no assets, the bank makes the loan to the company, secured by the assets of the company.
- The ESOP pays out the original owner(s) and is given their stock.
- Over time the ESOP repays the loan.
An ESOP thus enables the buyout transaction to be accomplished out of future corporate earnings, rather than current employee savings, with employees making contributions to the ESOP trust to repay the loan from pre-tax earnings.
For the seller, all the evidence demonstrates that if the business is valued properly pre-sale, an employee buyout will deliver a fair market price for the business. A well structured ESOP exit may also qualify the owner/seller to defer paying capital gains taxation on the sale.
The owner does not have to sell the business as a whole or all at once. Subject to agreement, payment can be taken over time and the owner stays on in a previously agreed role thus earning several more years income.
ESOPs are criticized for the complications and cost involved in setting them up. There are potential complexities but experience suggests that final planning of an employee buyout can be accomplished in anything from two to 18 months and can sometimes prove simpler and less antagonistic than a management buyout or trade sale.
The tax advantages that accrue to ESOP arrangements and the fact that the owner has a dependable buyer arrangement in place makes selling to employees an option in which the benefits well outweigh the costs of setting up the ESOP deal.
The key to successful exit via an ESOP is proper planning in the initial stages covering three critical factors.
- Establishing exactly what the owner wants to achieve: Utilizing an ESOP for buyout demands precise definition of the requirements of the seller (what proportion of interest they want to divest, over what period, will they accept the fair market price of the business, do they want to maintain a continuing role for other family members in the business and so on).
- Having an effective employee team and capable management: If the current employee team isn’t strong on the fundamentals of how the business operates, lacks managerial capability or doesn’t get along as a team then they will fail to convince financing institutions of their capability to manage the business and maintain loan repayments. Some restructuring, retraining and development of leadership skills in employees, particularly those who will take a management role, might be an essential prerequisite to ESOP buyout in these circumstances.
- Putting the business in a financially viable position: A successful employee buyout could be defined as the purchase of predictable cash flows at an economically reasonable price. An ailing business won’t bring a good sale price for the retiring owner or be attractive to lending institutions. The best time to consider an ESOP exit is when the business is in good condition since it must have the ability to generate cash flows sufficient to enable the repayment of debt and provide a satisfactory return on equity. The longer the period of grooming that can be put into preparing the business before discussing an ESOP the better.
Selling a business to the next generation may mean putting it into the hands of people who lack the technical expertise or personal desire to carry it on successfully; selling to external buyers can be time consuming, costly and will open up the business to intense scrutiny; liquidation of the assets will almost certainly not take into account goodwill and is likely to yield the lowest return.
Consequently, an increasing number of owners facing a succession decision are choosing to sell the business to their employees. Selling to employees can provide an attractive exit route that is tax efficient, guarantees fair market value for the business and has the added social benefit of safeguarding jobs and preserving services within the community.
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