It’s not an exaggeration that Employee Stock Ownership Plans (ESOPs) are becoming increasingly more popular with business owners in the last few years. KeyBank’s commercial banking team has experienced a strong uptick in ESOP business and has worked with numerous clients here in Connecticut and throughout the bank’s footprint to successfully transition their businesses to employee ownership.
There are several reasons for the growing popularity of ESOPs in business succession planning. For one, more than half of privately held firms in the U.S., or 2.9 million businesses are owned by baby boomers1 reaching retirement age and at the stage where they need to transition ownership in order to retire. In previous generations, family owned businesses typically were passed down to younger generations within the family. However, that expectation may not be realistic today; often, there aren’t clear successors or interest from natural successors to take on ownership.
At the same time, selling their businesses outright may not be feasible either. Even if a small or middle-market business is profitable with stable and moderate growth projections, it may not have the steep growth trajectory sought by private equity (PE) or strategic buyers in acquisition mode. It may be in a niche industry or in a rural location, which also limits prospective interest.
Finally, for owners with close ties to their communities, selling may risk their business being relocated or closed, which could jeopardize their legacy, their employees’ livelihood,and impact the greater population. Small and middle-market businesses help communities thrive, providing necessary services and goods, as well as employment for local residents and essential tax revenue to their towns. Private ownership comes with significant responsibilities and challenges, and one of the most important is succession planning.
For these reasons and others, many business owners who are ready to exit their businesses are considering ESOPs. ESOPs give closely held companies a sustainable and taxadvantaged2 path to succession, while also giving employees an opportunity to participate in the company’s profitability and success.
Benefits for Owners
Owners who sell in an ESOP transaction can benefit from:
• Selling minority positions, allowing them to diversify holdings while maintaining company control.
• Rewarding the employees who made them successful with a beneficial ownership and a retirement plan.
• Maintaining their community legacy by keeping their business open and in the same location.
• Sellers of C-Corp stock to an ESOP can elect to defer, and ultimately avoid, capital gains taxes if they reinvest in Qualified Replacement Property.
• Participating in upside growth after sale through warrants attached to seller debt, or by selling in stages.
Benefits for Employees
Employees can also win in an ESOP transaction because:
• They are not taxed on annual contributions or appreciation until they take a distribution, when they can roll over to an Individual Retirement Account (IRA) to defer taxes.
• Vested stock held by the trust for the employee is repurchased by the company (or by the ESOP) at retirement, death, disability, or termination of employment.
• At age 55 and 10 years of employment, participants are allowed to diversify a portion of their company stock holdings into traditional marketable investments such as mutual funds.
Benefits for Companies
At the company level, the benefits of an ESOP transaction are numerous:
• They can generally repay ESOP acquisition debt principal with pretax dollars, subject to limitations, increasing the ability to service debt.
• If an S-Corp is 100% owned by an ESOP, no distributions are required to pay the owners’ tax bill — ESOP trusts do not pay taxes.
• Acquisitions by an ESOP-owned company can be structured to allow target company sellers to defer capital gains, potentially lowering the acquisition price.
• ESOPS aid in employee retention and recruitment, which is especially important in a tight and very mobile labor market like the one we’re experiencing today.
• Ownership motivates high performance from employees and aligns their interests with other stakeholders because they now share in the success or growth of the company.
The steps to establish an ESOP can be complicated. Business owners who are contemplating an ESOP should work with skilled ESOP practitioners to advise on the financial, tax, and legal implications. At KeyBank, our local commercial team partners with experts from across the bank, including a nationwide team that specializes in ESOP capital structures, to make the transition seamless and supportive to both the sellers’ and buyers’ interests. Throughout the process, KeyBank recognizes the goals of every participant – for an end result that is a success for all.
For more information on how KeyBank can help your business, visit www.key.com/businesses-institutions.