Although ESOPs are complex, highly regulated, and expensive to administrate, they can offer owners a tax-advantaged way to obtain liquidity. The following are characteristics that may indicate your company is a good candidate for an ESOP:
- Consistent Earnings and Cash Flow – When a company sells to an ESOP, owners will typically finance the transaction with debt due to the unique tax advantages associated with ESOP debt. However, annual debt service can be a significant drain on an ESOP company’s annual cash flow. Therefore, to ensure the long-term feasibility and success of the ESOP, it is critical that th
e company not only be able to meet its debt obligations, but also have enough cash flow to fund future capital expenditures and working capital. Companies with high-profit margins and consistent revenue streams generally make good ESOP companies. - Adequate Size and Employee Base – Statutory requirements limit the amount of stock benefits that can be concentrated among shareholders. Additionally, annual ESOP contributions are limited based on participants salary. Therefore, a company with a large employee base is a better candidate for an ESOP than a company with a small employee base. A good mix of “seasoned” and junior level employees is also helpful to smooth out the Company’s repurchase obligation as participants retire.
- Strong Entrepreneurial Culture – Companies that have a strong entrepreneurial culture are usually good ESOP candidates. Employees that understand the connection between their jobs, the company’s profit, and ultimate value will be incentivized to increase that value as they become owners.
- Desire for Partial Sale – One advantage of selling to an ESOP versus sale to a third party is the option of a partial sale. In most cases, strategic buyers and private equity firms are only interested in buying a controlling interest. This is because these types of buyers want to influence the business operations to enhance their return on investment. In the case of an ESOP, partial sales of at least 30% are allowed. Owners may prefer a partial sale initially to retain control, continue legacy operations, and keep leverage levels reasonable. The remaining interest can be sold gradually, over time depending on the cash flow of the business. This structure offers a level of flexibility many owners are attracted to.
