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Creating a new ESOP vs. Selling to an Existing ESOP

The advantages of ESOPs are appealing, but it may not be feasible for every company. Selling to an existing ESOP company could make more sense for some businesses. 

A. Creating a New ESOP

Several factors, at minimum, must be present to make you a good candidate to sell your company to an ESOP:

  1. The company is making enough money to buy out an owner. The company must be generating enough cash to buy the shares, conduct its normal business, and make necessary reinvestments.
  2. If the company is borrowing to buy the shares, its existing debt must not prevent it from taking out an adequate loan. Similarly, the company must not have bonding covenants or other agreements that prohibit it from taking on additional debt.
  3. If the seller wants to take the tax-deferred rollover, the company must be a regular C corporation or convert from S to C status. S corporations can establish ESOPs, but their owners cannot take advantage of the tax-deferred rollover described above.
  4. The company is large enough. Though rules of thumb vary, ESOPs generally work best for companies with at least 20 employees due to cost, complexity, and certain ESOP rules.
  5. You are willing to take on the complexity and costs of setting up an ESOP. Selling a business is not inexpensive or simple no matter how you do it. The chart at the end of this article compares selling to an ESOP or an ESOP company versus selling to another buyer both in terms of costs and complexity. An ESOP sale will take at least six months and usually 9-12 months to set up, including getting a trustee and an appraisal, creating plan documents, and obtaining financing. The transaction costs typically run between $100,000 and $500,000 depending on the size and complexity of the deal and whether the advisor is taking a success fee (usually charged if the advisor is helping you consider other sale options as well).
  6. The seller(s) must be willing to sell their shares at fair market value, even if the ESOP pays less than an outside buyer would. An ESOP will pay the appraised fair market value based on a variety of factors, but sometimes an outside buyer can pay more for a company if it has a particular fit that creates synergies that go beyond what the company is worth on its own.
  7. Management continuity must be provided. Banks, suppliers, and customers will all want to be persuaded that the company can continue to operate successfully. It is essential that people be trained to take the place of departing owners to ensure a smooth transition.

If any of these or other reasons is enough to convince you not to sell to an ESOP you set up in your own company, you might consider instead selling to an existing ESOP company. We will turn to that issue next.

B. Selling to an ESOP Company Instead of to an ESOP You Create

If you like the idea of an ESOP, but would rather not set up one in your own company, there can be a lot of compelling reasons to sell to an ESOP company instead of another buyer:

It’s good for the people who helped build your business: Imagine standing in front of your employees and saying, “I have some good news and bad news. The bad news is that I am selling the company. The good news is that you will be the new owners, and it won’t cost you a thing.” That, in fact, is just what some owners have done. For a lot of owners who sell to an ESOP company, this opportunity to see the people who helped build the business become owners is a key factor in their decision.

You get a fair price and maybe a tax benefit: The ESOP company will generally make a competitive offer and, as we discuss in Structuring a sale to an existing ESOP, in some cases, you may be able to defer taxes on the gain.

ESOP company acquisitions have a very good track record: Every industry and community has stories about companies that were sold to a big company or a private equity firm and then saw some or even all its employees lose their jobs, get relocated, and/or see a reduction in pay or benefits. Research on ESOP company acquisitions  shows they have a remarkably successful track record. Employees are very rarely laid off and usually end up with better overall benefits because they get included in the ESOP. ESOP companies tend to be very conservative in their acquisitions, in part because they have to be able to demonstrate to the ESOP plan trustee that the transactions are prudent. They also tend to be very employee-focused, understanding that what makes acquisitions fail or succeed more than any other factor is how well the target company’s employees are integrated into the workforce of the new owner.

On the downside, these transactions may take more time if they involve the “two-ESOP” model described in Structuring a sale to an existing ESOP that can help obtain the special tax deferral on the sale. Because ESOP companies cannot pay a highly synergistic price, if there is a buyer who wants to pay you a very high premium, the ESOP may not be able to match it.