United States

Selling your business to your employees

ESOP pros and cons to consider

INSIGHT ARTICLE

As an owner of a closely held business looking to sell your company, your most ideal buyer could be right under your nose—your very own employees. An employee stock ownership plan (ESOP) may be the right tool to help with this sales effort. 

How does an ESOP work?

An ESOP is a qualified retirement plan that provides a retirement benefit to employees. Similar to a 401(k) plan, the employer contributes to the plan; the plan trustee allocates those contributions to the employees’ accounts and invests the contributions (in this case, in employer stock). The employees do not pay taxes on the contributions until the plan distributes the value of their account in some future year.  Unlike many other retirement plans offered by employers, an ESOP provides employees with an ownership stake in the company and gives current shareholders a market to which they can sell their stock.

Advantages for owner, incentives for employees

A primary advantage of using an ESOP in connection with the sale of your business is that you’ll have the ability to tap into a more readily available market for the sale of your company. You may find that there are a limited number of outside buyers, but an ESOP provides immediate buyers.

In addition, the sales process with third parties can be disruptive to the business. An ESOP transaction, when optimally handled, can be less of a distraction for the current workforce and operations and provides the potential to carry on the previous owner’s legacy. Adding to that, there may be a reduced likelihood of the company management or overall dynamics changing when utilizing an ESOP. Typically, the management team does not change, or you will choose successor managers within the company.

Another benefit to using an ESOP is that the transition can incentivize employees to remain loyal to the company, as they feel they have a greater stake in the business due to their stock ownership. This can contribute to increased productivity, commitment to a growing and vital future of the business, and overall employee retention.

ESOPs can also provide key tax deferral options. If you own a C corporation, you can defer tax on the sale of stock to an ESOP if the ESOP owns at least 30 percent of the company, and you reinvest your proceeds in qualifying replacement securities. This tax deferral possibility is not an option if your company is an S corporation, but a selling shareholder receives capital gains treatment on the stock sale to an ESOP, which may not always be the result when selling the company to an outside buyer. There are additional tax opportunities and liabilities to consider. It’s important to discuss your options with your tax and business succession advisors.

Key questions

To execute a sale via an ESOP, you must initially address some fundamental questions, including:

  • Will you sell your entire company or implement a staged transaction, and have you developed a succession plan reflecting this strategy?
  • Which employees will manage the company, and do you have the right talent in place for roles such as CEO, operations, finance and more?
  • Have you vetted your successor, discussed the ESOP details and do you have agreement with this new leader on next steps?
  • Do you have a plan for how to communicate the ESOP transaction with your employees?

Finally, there are additional non-ESOP options and tools to consider when selling your business to employees. You should consider tax-qualified retirement plans, nonqualified deferred compensation plans and other strategies that can provide benefits and tax opportunities to the business. Discuss with your advisors now to weigh these opportunities and your overall business transition planning.