How ESOPs Can Harm Exiting Business Owners

Submitted by John Brown on Fri, 02/23/2018 - 6:00am
Sometimes, ESOPs can be more complex than they seem.

This article continues our series describing the advantages and disadvantages of the five primary Exit Paths that business owners might choose. In our last article, we showed you some of the benefits of the uncommon but increasingly popular Employee Stock Ownership Plan (ESOP) Exit Path. Today, we’ll examine the disadvantages of ESOPs. As always, our goal is to introduce important issues so that business owners, Exit Planning Advisors, and Advisor Teams can communicate and strategize on the same terms.

For many business owners who pursue ESOPs as an Exit Path, the allure of minimizing tax consequences and protecting their employees blinds them to the disadvantages of this Exit Path. Because of their growing popularity, some owners who favor ESOPs find the disadvantages of ESOPs sneaking up on them. To preempt these problems, let’s look at five disadvantages to ESOPs. Per usual, we will look at these disadvantages in the context of the three fundamental goals of all BEI Exit Plan designs:

1.         Maximize the amount of money the owner receives.

2.         Keep the owner in control until he or she receives all monies.

3.         Minimize the owner’s risk.

Challenges to Business Owners in Sales to ESOPs

Challenge 1: Financial Security

Selling to an ESOP poses several challenges to business owners regarding their financial security. Foremost among these problems is that it may be necessary for the owner to accept a promissory note for part of the purchase price. Owners may also be required to personally guarantee the bank financing that is used to acquire their stock.

In addition, establishing and operating an ESOP can be expensive, and when compared to a sale to a strategic buyer, owners who sell to ESOPs may leave money on the table.

Finally, selling to an ESOP requires that the business owner’s management team can continue the company’s success. If management fails to produce the necessary cash flow to pay off any debt to the former owner after the owner exits, the owner’s financial security can be put in jeopardy.

Challenge 2: The Time Factor

Of all risks, ESOPs tend to threaten owners’ time more than anything. Consider the following:

  • ESOPs typically require bank loans to purchase the owner’s stock. Those loans are paid back using the company’s future cash flow. If the owner is no longer involved in the business or does not control the future of the company, but has pledged sale proceeds as security for the bank loan or has not received all of the purchase price at closing, the owner risks losing the unpaid portion of the sale proceeds.
  • After the owner/seller has received full payment, ESOPs can still put a strain on the future cash flow of the business through loan repayments (if the owner’s stock sale was financed) and the obligation to purchase stock from the ESOP accounts of departing employees.
  • The level of due diligence is similar to that of a sale to a third party. If a company has undisclosed liabilities, environmental liabilities, or an over-concentration (or too few) customers, the buyer (i.e., the ESOP) will lower its purchase offer and demand warranties and representations (between trustee and seller) to mitigate its risk.

Challenge 3: The Time Margin

There are normally no disadvantages in terms of time margin, because owners can create the time margin they desire. They can either sell gradually and remain involved, or they can create the time margin by cashing out more quickly and leaving.

Challenge 4: Tax Consequences

Though properly created ESOPs tend to create positive tax consequences, there are risks. In return for favorable tax treatment, the IRS and Department of Labor subject ESOPs to a high level of scrutiny and regulation. That’s the price owners pay for the significant tax benefits the IRS provides to ESOPs.

Challenge 5: Values-Based Goals

Typically, there are no disadvantages in terms of values-based goals for owners looking to sell to ESOPs. However, this assumes that management will maintain the company’s culture, location, legacy, or other related goals. Thus, vetting management teams is important for owners considering an ESOP.

Challenge 6: Successor

A capable and motivated management team that will remain with the company after ownership is transferred to an ESOP is critical. If a management team cannot operate well in an employee-ownership culture, an ESOP may not be a viable Exit Path.

Addressing These Challenges

Of all Exit Paths, ESOPs can be the most complex. That’s why BEI has developed a variety of bespoke designs and tools to minimize or eliminate the challenges in sales to ESOPs. These designs and tools are part of the pre-sale planning and execution process that focuses on achieving all of an owner’s goals and aspirations.

Keep in mind that the actions required to mitigate the challenges described here may take years. If owners wait to begin planning to transfer ownership of their companies to ESOPs until they are ready, there is little advisors can do for them. Because most owners would like to exit within five years, advisors need to tell owners about the advantages and disadvantages of ESOPs immediately.

In our next article, we’ll look at the most popular yet most dangerous Exit Path of all: no Exit Path.



 Tags:

Are you ready to help your clients exit?

Have a question before getting started? Schedule a meeting with BEI or Contact Us

Schedule a Meeting to Discuss Exit Planning Solutions