What is an ESOP?

Employee Stock Ownership Programs (ESOPs) have become increasingly popular among companies as a way to engage and retain employees while also providing a unique ownership structure. 

This exit path allows employees to own shares in the company they work for, which can result in significant benefits for both the business and the community it serves. 

In this blog post, we’ll explore two examples of ESOPs in action within the Colorado community. 

Benefits of an ESOP: 

The main benefit of an ESOP is that it incentivizes employees to work harder, stay with the company longer, and feel more invested in its success.

ESOP guru and BEI Member, Kelly Finnell had the opportunity to work with Denver Restaurant Group, Edible Beats, to create an ESOP for its employees. 

Kelly and his team at Executive Financial Services  worked to develop an ESOP for Edible Beats Founder, Justin Cucci, and his hard-working team of 325+ employees. Here’s what Kelly and his team were able to accomplish with Edible Beats through the creation and implementation of an ESOP: 

1. Employee Benefits:  Employees earn shares based on their tenure and salaries. More responsibilities come with a higher salary, and employees in turn get more shares within the company. 

At Edible Beats, every employee regardless of tenure was eligible to be included in the plan. According to Founder, Justin Cucci, new employees must wait a year from the start of employment in order to get vested, and will earn 25% of their shares each year after.  

2. Improved Retention: ESOPs are a powerful tool for employee retention. When employees feel like they have a stake in the success of the company, they are more likely to stay with the business for the long-term. This reduces turnover costs and ensures that the company retains valuable talent.
3. Increased Motivation: ESOPs can be a powerful motivator for employees. When employees own a piece of the company, they are more likely to take ownership of their work and feel more invested in the success of the business.

Cucci spoke about how life changing it can be to own shares in a company. Equity provided from shares can assist in purchasing a home or a business down the road. 

“The only thing the shares can't do is be transferred or sold to another person. Shareholders who want to disinvest must sell their shares back to Edible Beats”, wrote Linnea Covington.

4. Heightened Productivity: Companies with ESOPs often see an increase in productivity. This is because employees feel more motivated to work harder, are more invested in the company's success, and have a greater sense of ownership.

“For Cucci, creating the ESOP means he doesn't have to sell off Edible Beats in pieces, or to an owner who may dismantle the business that he built so carefully. Eventually, the idea is to have the Edible Beats restaurants completely employee owned.” 

For more details on Edible Beats and their recent ESOP strategy, check out this article from Restaurant Hospitality written by Linnea Covington: Denver Restaurant Group Offers Stock To Employees.

Building a Sense of Community: 

So, how does an ESOP positively impact the community? Let’s take a look at a long time Colorado favorite, Beau Jo’s Pizza. 

Chip Bair, the owner and founder of Beau Jo's pizza restaurant in Idaho Springs, announced at the 50th anniversary celebration that he’ll be selling the business to his employees through an Employee Stock Ownership Plan (ESOP). 

As a Colorado institution that’s served approximately three million pies over the years, Beau Jo’s move to an ESOP will ensure that the business will remain in the hands of employees who have helped make it a success over the years. 

This move demonstrates Bair's commitment to the community and his employees who have helped make Beau Jo's a beloved institution over the past half-century. Here’s how: 

1. Community Involvement: ESOPs provide local employment opportunities to community members and support the local economy. Idaho Springs, CO, has faced an economic downturn as mines across town shut down over the years. Luckily, the newly employee owned pizza joint also calls Idaho Springs home and has been able to provide jobs for many that lost their jobs of the years, establishing Beau Jo’s as a pillar in the community. 

In an article published by Jason Blevins for The Colorado Sun on Employee Ownership and Creating a Legacy, Jason wrote about an Idaho Springs Local, “Alex Dunn worked at Beau Jo’s during college and in the summers when she was a teacher. She started working full-time at the Idaho Springs restaurant 17 years ago and now she is the general manager.” 

Leaving a Lasting Legacy

In addition to the benefits mentioned above, ESOPs are also a valuable tool for building a lasting legacy. ESOPs can help to paint the picture about: 

1. Long-Term Perspective: When employees own a piece of the company, they tend to take a longer-term perspective. This means that decisions are made with the future in mind, rather than just short-term gains.
2. Succession Planning: ESOPs can be an effective way to facilitate succession planning. By gradually selling shares to employees, business owners can ensure that the company stays in the hands of those who are committed to its success.
3. Increased Value: Companies with ESOPs tend to be more valuable, as they have a committed and motivated workforce. This can result in higher profits, which can be reinvested in the business, the community, or other initiatives that support the company's long-term success.

The Bottom Line

An ESOP can provide significant benefits for both the business and the community it serves. They can improve employee retention, motivation, and productivity, while also stimulating economic growth and community involvement. Additionally, ESOPs are a valuable tool for building a lasting legacy.

 

BEI believes that some of the best insights and advice come from peers who are actively using Exit Planning strategies in their daily work. For this reason, we welcome content from our members, niche guests, and our strategic partners, as additional ways to provide high-quality advice and resources for you and your planning practice. 

This week, one of our newest partners, CSG Partners, gives a high-level overview of multiple M&A transaction types and the pros and cons of each. Reviewing these M&A options, as well as how they relate to a business owner’s goals will prepare you for conversations with your owner clients.   

 

Choosing the Right M&A Option for your Clients

By David Blauzvern, CSG Partners 

The difference between a positive liquidity event and seller’s remorse often comes down to strategic alignment. Deal terms and pricing are important, but the right structure often matters more. The "right" transaction generally reflects a business owner's distinct goals and needs.

 

Common M&A Options

To illustrate, let's explore three transaction types: strategic sales, private equity deals, and leveraged ESOPs. Each carries its own unique attributes, pros, and cons. While "perfect fit" is an elusive M&A concept, certain options may offer greater situational utility. With that in mind, we'll also look at each strategy through the lens of common shareholder priorities.

Strategic Sale

When business owners envision an M&A exit, this option is usually top of mind. Generally speaking, a larger player or deep-pocketed upstart will purchase a seller's company to gain assets, intellectual property, customers, and/or sales territory.

Pros

• Widely understood process
• Transaction valuations may exceed fair market value
• Strategic buyers often have a greater appreciation of market dynamics and nuances
• That familiarity may facilitate a smoother, post-transaction integration process

Cons

• Confidential company information is shared with potential competitors throughout process
• Sale proceeds are fully taxable
• Employees, including tenured staff and top talent, may not be retained 
• Departing staff are often left with hard feelings and little to show for their efforts

Private Equity

Most private equity (PE) deals are leveraged buyouts. To complete an acquisition, a financial buyer will lever-up a company’s balance sheet with private debt. Once in charge, the acquirer may seek to professionalize operations and drive future efficiencies. 

Pros

• Selling shareholders will often receive a substantial portion of the purchase price upfront
• PE firms generally have the means and expertise to grow and/or scale a business
• Sellers may also financially benefit from future add-on acquisitions and M&A activities 

Cons

• Sale proceeds are fully taxable
• Sellers usually reinvest a portion of their proceeds in the post-transaction structure
• PE firms often have final say in future operational, strategic, and M&A decisions
• Risk of putting excessive leverage on the company

Leveraged ESOP

Similar to a management buyout, a company finances the purchase of an owner’s stock. But in this instance, the buyer is an employee trust, rather than a management team.

Pros

• Sellers can eliminate capital gains taxes on sale proceeds and maintain potential upside
• Company receives tax deductions equivalent to the sale value
• Company can become a tax-free entity as a 100% S Corp ESOP
• Board of directors continues to oversee operations

Cons

• Employee trust cannot pay more than fair market value
• Highly structured deal process
• Regulatory oversight by Department of Labor and IRS
• Outside lenders often provide non-recourse financing, but this may only cover a portion of the transaction (seller notes fund the remainder)
•  

Evaluating M&A Options Vis-a-Vis Owners' Goals

So, let’s consider these transaction types in light of common shareholder priorities. 

Seeking Complete Business Exit

Owners that want to cash out and not look back should give serious consideration to a strategic sale. This option likely represents the cleanest of breaks – free of continuing management duties and most other ongoing entanglements.

Of course, a third-party sale is subject to capital gains taxes, so a premium valuation can take on outsized importance.

Looking to Gradually Step Back

For shareholders seeking to pare back their day-to-day involvement while diversifying their personal portfolio, a private equity or ESOP sale may be the right option. Both can provide a partial liquidity event with potential upside. Ongoing “skin in the game” takes the form of rolled equity in a PE sale and retained stock and/or stock warrants in an employee stock ownership plan transaction.

Businesses seeking an infusion of outside talent could be well-served by a private equity buyer. These firms often specialize in industry-specific transactions and provide operational know-how and human capital to scale their portfolio companies. The common trade-off is a loss of independence. While selling shareholders may play a role in the restructured entity, day-to-day control is generally assumed by the PE firm.

If a company already has the bench strength to facilitate a gradual leadership transition, an ESOP may be an attractive PE alternative. Sellers and their companies can reap the associated tax benefits with only a 30% sale to an employee trust. Even in the event of a majority or 100% ESOP sale, the company’s board of directors will continue to operate the business, and sellers can continue to earn a salary and a maintain meaningful role, without being obligated to stay. 

Solely Focused on Financial Diversification

While certain owners may be fully invested in their business, it could be the right time to take chips off the table. The case for an ESOP is compelling under these circumstances. Selling shareholders can complete a partial, fair market value sale to an employee trust and still maintain a majority stake. 

Under a minority ESOP, operations and leadership remain largely unchanged, while the company benefits from increased cash flow, thanks to the ESOP’s tax incentives. Employee-owned companies, on average, are also more stable and productive than their non-ESOP equivalents. The stock incentive can help foster increased employee engagement and provide a unique incentive for attracting and retaining top talent.

An employee-owned company also has significant flexibility to accommodate evolving stakeholder goals and future growth. Partial ESOP sales can be followed by a range of transactions including secondary sales, M&A or PE deals, and ESOP plan terminations. As a result, owners have the latitude to actively shape their business legacies even after a minority employee stock ownership plan sale.

 

In Conclusion

The sale of a company is one of the most significant transactions a business owner will face, and it can have a huge impact on their future and the legacy they leave behind. An educated seller will almost always end up with the best possible outcome among available options. Taking the time to explore the full impact of transaction alternatives, on all stakeholders, puts business owners in a position to avoid surprises while choosing the best path forward.
 

As an Exit Planning Advisor, you may be faced with strong, contradictory opinions from your business owner clients on a variety of Exit Planning options. One exit path that many people have misconceptions about is Employee Stock Ownership Plans (ESOPs).  

The confusion surrounding this exit path may be for a few reasons. The Employee Stock Ownership Plan (ESOP) is the main source of employee ownership in the U.S, however, ESOPs are not the only option available for employee ownership. Another misunderstanding is that this exit path requires employees to purchase stock or that it works like an equity compensation plan. Rather, ESOPs are entities of federal law, governed by many of the same rules as 401(k) plans, funded entirely by the company, and subject to oversight by the IRS and U.S. Department of Labor (DOL).  

These misconceptions form due to the complex nature of this exit path. For the purposes of this article, we’ll leave government-created complexities to ESOP specialists. Instead, it will provide you, as an Exit Planning Advisor, with the pros and cons needed to make an initial recommendation to a client about whether they should pursue an ESOP.  

The Appeal of an ESOP

To a business owner unfamiliar with this path, they may ask, “What is the purpose of an ESOP?  

According to the National Center of Employee Ownership, “ESOPs are most commonly used to provide a market for the shares of departing owners of closely held companies, to motivate and reward employees, or to take advantage of incentives to borrow money for acquiring assets in pretax dollars.” 

Simply put, an ESOP is a type of employee benefit plan that acquires company stock and essentially enables employees to own part or all of the company they work for. 

The next question is typically along the lines of, “How does an ESOP work, and is my company a good candidate?”  

The Process of an ESOP

In an ESOP, a company sets up a trust fund and then contributes new shares of its stock or puts in cash to buy existing shares. As an alternative funding option, the ESOP can borrow money (from a bank, seller, or both) to buy new or existing shares. With borrowed money, the company makes cash contributions to the plan so that it can repay the loan over time.  

Employees can accumulate shares in their retirement accounts as they are allocated over time, and then cash out those shares when they retire or leave the company. These allocations are distributed to employees according to relative pay, or a formula that deems more equal distribution. At this time, employees receive a significant retirement benefit, and the owner reaps the benefit of securing a successor while being able to exit on their own terms. In addition, the ESOP provides continuity during the transition of ownership.  

Just like every exit path, ESOPs come with a list of pros and cons. While this is not an exhaustive list, Exit Planning Advisors should be able to articulate these benefits and drawbacks to clients looking into an ESOP transition.  

Pros of ESOPs as an Exit Path 

Financial Security 

Owners can receive the financial security they desire post-exit through partial or complete sale of their ownership interest. ESOPs also allow them to stay in control until they are fully paid, as well as enjoy effective control even after they are paid if they choose. 

Time  

ESOPs can be designed to accommodate an owner’s departure date, as well as give owners the chance to leave gradually or remain involved in some way for those owners who face the fear of letting go.  

Employee Satisfaction & Culture  

A values-based goal of many business owners is to carry on the legacy and mission of their business beyond their exit. ESOPs give employees ownership rights, giving them a stake in the future growth of the company. This transfer method is more likely to continue the culture, legacy, and community impact of the business.  

In addition, ESOPs generally include incentive plans for key employees.  

Tax Benefits 

There are several tangible tax benefits provided by ESOPs to both business owners, and employees:  

• The future income of S corporations is not taxed, allowing the company to invest and increase cash flow.  

• Proceeds from the sale of a business owner’s stock in a C corporation may be entirely deferred.  

• Payments made to the ESOP by the company are tax-deductible as they are then used to buy the business owner’s stock in the company.  

• Cash contributions to the ESOP are tax-deductible, whether used to buy shares from owners or to build up a cash reserve.  

• Loan repayment contributions to the ESOP are tax-deductible too, meaning that ESOP financing is done in pre-tax dollars. 

• Employees don’t pay tax on their personal contributions to the ESOP – only during the distribution period at the time of their departure or retirement.  

Cons of ESOPs as an Exit Path 

Financial Security 

The cost to start and operate an ESOP can be substantial – NCEO states even the simplest of plans for small businesses can start at upwards of $40,000. Owners may also take on debt in this type of exit path, relying on the ability of the business to use future cash flow to pay off these debts to the owner.  

Time  

If the owner does accept promissory notes for part of the purchase price, taking on the debt mentioned above, they can be exposed to long-term risk since repayment is subjective to the company’s future cash flow. Regardless of the owner’s exit timeline, this repayment could take a long time and added risk may stall or divert the timeline altogether.  

Employee Satisfaction & Culture 

Many owners hope that as a trade for ownership, employees will have higher motivation and performance given their stake in the company. However, ESOPs will only improve corporate performance if combined with opportunities for employees to participate in making decisions.  

In this exit path, the successor is ultimately the employees; therefore, an ESOP would not be viable if the company’s management team won’t operate well with that model.  

Lastly, the employees who are members of the ESOP choose to invest their retirement plan savings in a single company. This lack of diversification can put them at risk of losing their income and their savings if things go south with the business.  

Tax Stipulations  

The IRS & Department of Labor (DOL) subject ESOPs to a high level of scrutiny and regulation due to the significant tax benefits the IRS provides to ESOPs. Additionally, ESOPs can’t legally be used in partnerships and most professional corporations.  

Action Items for Exit Planning Advisors:  

Regardless of exit path, the biggest benefit of Exit Planning as early as possible is that Exit Planning Advisors can help mitigate the disadvantages of the chosen exit path.  

Regarding ESOPs, Exit Planning Advisors should keep their finger on the pulse of all government regulations and changes with these plans. They should also familiarize themselves with alternative recommendations to give to their clients so they can make suggestions on different exit strategies if the ESOP proves to be an ill-suited solution for a particular situation.  

To learn more about ESOPs, or to gain knowledge on other Exit Planning solutions, schedule a meeting with BEI today.  

If you missed the webinar featuring Kelly Finnell, Founder & President of Executive Financial Services, Inc. (EFS), you can watch the recording and download the presentation slides at the link below!