Business owners looking to find ways to sell their ownership interests can sell to other buyers, liquidate, pass the business to a family member, or ask key employees to purchase the company. For many owners, some of these potential solutions quickly prove impractical – key employees rarely have sufficient funds to pay fair market value (see our Guide to Employee Ownership for Small Businesses), and there may not be a family member interested in taking over the business. Liquidating is often seen as a last resort, and there may simply not be a potential outside buyer to whom the owner would feel comfortable entrusting the future and character of the business.
Every business owner thinking about their exit should consider a tool created by Congress in 1974, an employee stock ownership plan (ESOP). Done right, an ESOP can pay fair market value and also offer the most tax-favored way to transfer ownership to the people who helped build the company. ESOPs have a long history of preserving the character of private companies and supporting their long-term growth, and the vast majority (92%) of business owners who sell to an ESOP report being happy with the transaction in hindsight.
The Basics
ESOPs are a kind of retirement plan. A sale to an ESOP can be all at once or gradual, for as little or as much of the stock as desired. The seller receives fair market value for the shares and can also benefit from tax incentives. After the sale, the former owner can stay with the business in a variety of capacities, if desired.
For the employees, no contributions are required to purchase the owner's shares. Instead, the company uses future, pretax profits to fund the plan’s purchase of shares on their behalf. Over time, each employee builds up a holding of company stock designed to be used in retirement.
A gradual purchase can be funded by annual contributions to buy shares. More commonly, the ESOP transaction uses borrowed money to buy a large block or all the shares at once. If financed, the loan can come from a bank, a seller note, or (often) both, The plan is governed by a trustee who votes the shares, but the board appoints the trustee, so changes in corporate control are usually nominal unless the plan is set up by the company to give employees more input at this level.
ESOPs are not right for everyone, Companies need to have enough profit to buy the shares and continue to operate successfully. Initial costs, while lower than typical M&A fees, are significant. ESOPs work best in companies that have or create high-involvement cultures.
Next Steps
- For an overview and case studies of using an ESOP for business transition, read our booklet Who Should Own Your Business After You.
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If you are ready to learn about an ESOP in detail, our pre-feasibility toolkit steps you through screening questions, transaction details, and a tax advantage calculator.
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See our book Selling to an ESOP and Financing the Deal.
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Attend one of our in-person meetings or become an NCEO member to attend live or prerecorded webinars.
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See a comparison table of different forms of employee ownership.
- Contact us with questions or to request to be connected to a peer company that has done an ESOP transaction.