Improving Succession Planning Alternatives

For a closely held business owner, succession planning usually means choosing among a limited number of imperfect alternatives. A sale to a strategic buyer or private equity firm can generate liquidity, but ownership and control pass outside the business. A management buyout keeps the company in familiar hands, but the management team has to finance the purchase, most often placing substantial debt on the transaction. A family transfer only works if there is a capable and willing successor who actually wants to own and run the company.

A traditional Employee Stock Ownership Plan or ESOP belongs on that flawed list as well. In an ESOP, an Employee Stock Ownership Trust or ESOT buys some or all of the operating company from the owner. Borrowed money is often used to finance the purchase, with the operating company ultimately responsible for supporting that debt. The owner receives liquidity and the company can remain independent, but the owner has still sold some or all of their business.

For an owner who intends to sell, that can make perfect sense. It's a much less attractive answer for an owner who wants to reward employees and begin planning for succession without selling the company.

Traditional ESOP Mechanics

Since the ESOT is buying company stock, the shares have to be independently valued. The ESOP trustee represents the interests of the employees participating in the plan and generally cannot cause the ESOP to pay more than fair market value for the stock.⁷

That can matter when an owner is considering other buyers. A strategic buyer may place a higher value on a company because of what the acquisition adds to its own business. An ESOP transaction is based only on the fair market value of the company being purchased.

Section 1042 of the Internal Revenue Code can provide a significant tax benefit when qualifying closely held C corporation stock is sold to an ESOP. The owner must have held the stock for at least three years, and the ESOP must own at least 30% of the company after the sale. The owner can defer capital-gains tax by reinvesting the proceeds in qualifying stocks or bonds of U.S. operating companies within the required period.⁶

That tax benefit requires an actual transfer of ownership, though. If an owner sells 49% of the company, the owner keeps the future upside on the 51% they still own but gives up the future upside on the 49% sold to the ESOP.

ESOP transactions also commonly use seller financing. Instead of receiving the entire purchase price at closing, the owner accepts a promise to be paid over time. That creates real risk for the seller. The seller is counting on the company to generate enough cash to make those payments.

Some financed ESOP transactions also include warrants, which give the seller the right to buy shares later at a specified price and under specified terms. Warrants can provide some participation in future appreciation, but they are not the same as continuing to own the shares themselves.¹⁰

Financing creates risk for the company as well. Bank financing, seller financing, or both ultimately have to be supported by the operating company's cash flow.

The loan payments continue even when business results fall short of projections. Cash used for debt service is unavailable for working capital, equipment, expansion, acquisitions, or other business needs. If the company can't make the payments, it may have to refinance or restructure the debt, cut other spending, or put additional pressure on the business. Federal fiduciary guidance specifically requires consideration of the company's ability to service ESOP debt if the projections used in the transaction are not achieved.⁴

A traditional ESOP buys operating-company stock from the owner. The owner receives liquidity, and employees gain ownership through the ESOP. The owner also gives up the shares that were sold and the future upside that goes with them. In a leveraged transaction, the company also takes on the burden of supporting the purchase debt.

Succession Without Selling First

Many owners begin succession planning years before they are ready to sell. They may want to reward employees and give them a real stake in the company's ongoing success while continuing to own and operate the business themselves.

4ESOT allows employee ownership to begin without requiring a sale of the operating company.

Under the 4ESOT structure, employees receive their ownership benefits through a separate S corporation owned by the ESOT. The business owner and family continue to own the operating company.

No operating-company shares have to be sold to establish employee ownership. There is no need to finance an ESOP purchase of those shares, and the owner continues to own the future appreciation of the operating company.

The eventual succession decision remains open. The business can later be transferred to family, sold to management, sold through a traditional ESOP transaction, sold to an outside buyer, or simply retained.

For an owner who is not ready to sell, employee ownership can begin without deciding today who will eventually own the business.