Another strategy may be to combine a 1042 rollover with a contribution to a Charitable Remainder Trust (CRT), providing a charitable deduction while also generating income through annuity payments. Alternatively, shares can be donated to a CRT before the ESOP transaction, with the ESOP later purchasing the donated shares from the trust.
When ESOPs Aren’t a Good Idea
Owners and founders should be mindful when an ESOP isn’t a viable exit planning strategy. Companies that are unprofitable, already heavily leveraged, or have volatile earnings may struggle to support the debt obligations associated with an ESOP. However, even underperforming businesses might still appeal to strategic buyers. Additionally, the upfront and ongoing costs of establishing and maintaining an ESOP can be significant. These include transaction-related fees for legal counsel (ESOP attorney, trustee attorney, lender attorney) as well as recurring expenses such as trustee oversight and annual valuations. For smaller businesses or those with limited earnings, these costs may outweigh the potential benefits.
In some cases, a company’s demographics may make an ESOP less viable. For example, the typical morale and retention boost associated with an ESOP may not apply if the company has a high proportion of younger employees who are likely to leave anyway. Additionally, for certain companies, it may be challenging to reward key managers or transfer concentrated shares to family members under the structure of an ESOP.
That said, business owners have several exit options to consider – strategic sales, financial buyers, related-party transfers, and ESOPs. Under the right circumstances, an ESOP can be an ideal solution, offering liquidity, potential tax advantages, legacy preservation, and the opportunity to stay involved in the company’s future.
FAQs
Why haven’t I heard about ESOPs before?
While ESOPs have been around for a while, there are not that many experts in this field relative to other business sale structures. Many investment bankers are not as versed in the ESOP structure, so it’s recommended less often than other alternatives. As well, often M&A advisors get compensated on the completion of a sale, so they might not be incentivized to recommend an ESOP.
Is an ESOP appropriate for a fast growing company?
A company’s valuation typically will increase dramatically as the expected growth increases. This may make an ESOP transaction too expensive for companies with high growth rates (~15% plus). With a higher valuation, the company may not be able to support the higher debt obligations. As well, buying back shares from employees when valuations are high from high growth rates could be problematic.
How do employees get liquidity from the ESOP?
The ESOP will typically provide liquidity at the market value based under certain events like retirement, separation from the company, disability, etc. Payment may be in a lump sum or in installments. Employees over 55 with over 10 years of service by law are allowed to diversify their company shares in the ESOP into other investments. Even if the ESOP company is privately-held, essentially a marketplace exists for the company’s shares.
My company has volatile earnings. Can I still do an ESOP?
The company’s cash flow should be able to support ongoing debt obligations. Businesses with volatile earnings may not be able to obtain bank financing and/or might have issues paying off the debt or seller’s note.
Does an ESOP work for family businesses?
Family businesses can often make for the ideal candidate for an ESOP transaction. If the goal is succession, an owner can use an ESOP to do a series of sales to reduce ownership and management responsibilities over time. The proceeds can also be used to equalize inheritances between children working in the business and children outside of the business.
Can I do a partial Section 1042 rollover?
Yes, you can defer capital gain taxes on the sale proceeds used to purchase QRP. On the proceeds that doesn’t purchase QRP, you can pay the taxes on that portion of the sale and invest it without the 1042 requirements.
What are the drawbacks of doing a Section 1042 rollover to defer taxes?
The main drawback to a 1042 rollover is that to fulfill the 1042 requirements, you must remain invested in QRP. If you have significant liquidity or spending needs, the rollover may not be appropriate. Moreover, you may be able to earn a higher reinvestment rate wihout the investment constraints of QRP.
Should I just buy bonds for my QRP to do a Section 1042 rollover?
Each person’s optimal investment portfolio is different, but buying just bonds for QRP likely earning a return lower than the overall market. Perhaps this strategy could make sense for older investors, but buying only bonds for QRP likely means buying very long dated maturities. This could lead to credit risk to the universe of issuers that issue longer dated bonds, and volatility from interest rate changes given the long duration of a bond only portfolio.
Will I get a lower price if I sell the business to an ESOP?
It’s possible that the ESOP would pay a lower price than selling to a strategic buyer that is willing to pay more to realize synergies from the acquisition. However, it’s possible that an owner may receive more after tax proceeds since the owner can benefit from a more valuable business as employees work to improve the valuation of the company through alignment of employees and owners. The owner can sell shares over time and receive greater upside from the ESOP tax savings, warrants they receive in the transaction, and other consideration.
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