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Are ESOPs Really More Complex and Costly Than Other Ways to Sell a Business?

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Are ESOPs Really More Complex and Costly

Using an ESOP for Business Transition Can Be Complicated, But Selling to an Outside Buyer Is Often Uncertain and Even More Complicated with Less Flexibility and Fewer Tax Benefits

When people describe the pros and cons of ESOPs, often they note that the plans are complex. ESOPs are somewhat more complex than 401(k) and similar retirement plans and do cost substantially more to install and somewhat more to operate, mostly because an annual appraisal is required for closely held companies. But ESOPs are not more complex than selling to a third party. The table below compares what issues come up in the sale of a company to an ESOP compared to a sale to a third party. It was prepared with the advice of professionals who have done both kinds of transactions. The table indicates that the overall level of complexity is similar, but ESOPs are much less risky in terms of the likelihood of finding a buyer. They are also considerably less costly, mostly because in the case of a sale to a third party, in addition to substantial legal, accounting, and sometimes other fees, the price paid to the seller is usually reduced by brokerage commissions paid by the buyer.  Sales to third parties also do not qualify for special tax benefits, as is the case with ESOPs.

Key legal documents

 
ESOP

Sale to Another Company

  • ESOP plan document
  • Trust agreement
  • Lender agreements
  • Corporate resolutions
  • Stock purchase agreements
  • Corporate governance agreements
  • Employee contracts /management incentives
  • Detailed selling memorandum
  • Sale agreement (similar to stock purchase)
  • Non-compete agreements (often)
  • Liens, escrow, security agreement, and personal guarantees
  • Corporate resolutions
  • Employee contracts /management incentives

Feasibility Studies and Preparation

ESOP

Sale to Another Company

Feasibility studies assess whether the company has sufficient payroll and cash flow to buy the desired amount of stock. Can be performed internally or with expert advice. Forensic due diligence rarely needed.

Companies must prepare a detailed and accurate description of the firm and its finances, prospects, and risks. Buyers will want to do a forensic due diligence investigation and sellers should do the same to assess the financial soundness of the buyer and the terms of the offer.

Valuation

 
ESOP

Sale to Another Company

Outside appraisal required; valuation based on fair market value.

In smaller deals, outside appraisal not required but recommended; in larger deals price usually set by controlled auction.

Terms and Risks

 
ESOP

Sale to Another Company

Plans can be structured in a variety of ways:

  • Flexibility in financing
  • Rules for operating the plan must comply with ERISA, but there is lots of flexibility in design.
  • Escrow may be, but usually is not, required.






Buyers will typically have multiple contingencies:

  • Earn-outs often required, often in the 10% to 20% range.
  • Escrow held back
  • Purchase price adjustments in companies that underperform post-transaction may be required based on working capital or earnings requirements
  • Buyers prefer to purchase assets, with potential tax and liability implications for sellers.
  • Financing may fall through

Time to sell

 
ESOP

Sale to Another Company

Once the seller has decided on doing an ESOP and its basic structure, four to six months.

Median formal offer to sale time is 10 months for companies in the small to mid-market range

Role of seller post-transaction

 
ESOP

Sale to Another Company

Flexible depending on seller interests.

Buyer will usually determine role in smaller deals; in large deals role is usually negotiable.

Sale of minority interest

 
ESOP

Sale to Another Company

ESOPs can buy any percentage of stock from any number of sellers

Buyers almost invariably want to buy the entire company

Success rates

 
ESOP

Sale to Another Company

If an ESOP is determined to be feasible, only rarely do transactions fall through once a decision to proceed has been made.

Overall, only about 25% of privately held businesses put up for sale are sold and only about 50% of businesses with 100 or more employees are sold.

Transaction costs

 
ESOP

Sale to Another Company

  • For most closely held companies, transactions cost between $80,000 and $200,000, with some larger and more complex transactions priced significantly higher. Fees include feasibility studies ($10,000 to $40,000), plan documentation ($20,000 to $50,000), valuation ($15,000 to $25,000), trustee fees if using an outside trustee ($20,000 to $70,000), plus any corporate legal fees and personal financial advisor fees for seller.

  • A small number of ESOPs will require investment banking assistance to raise financing, adding to costs.

  • No broker fees should ever be paid in an ESOP

  • The ESOP pays the diligence, financing, and legal fees out of contributions from the company.

  • Legal costs may be somewhat lower.

  • Feasibility and due diligence comparable to or higher than ESOPs, and considerably higher in larger deals.
  • Legal costs are similar for smaller sales and much higher for large sales. Appraisal costs, if needed, would be similar.
  • The buyer usually pays the diligence, financing, and legal fees. Broker success fees are generally between 5% and 12% of the sale price in sale prices under $5 million and drop as low as 1%-3% in larger transactions. These additional fees mean, for instance, that a $5 million sale might require about $300,000 in broker or investment banker fees; a $10 million sale would require $500,000 in these fees. These fees are in addition to other costs.

Tax Issues

 
ESOP

Sale to Another Company

If the company is or becomes a C corporation at the time of sale, and the plan acquires 30% or more of the shares, then that sale, plus any subsequent sales, qualify the seller to defer capital gains taxes by reinvesting in stocks and bonds of U.S. operation companies. No taxes are due until the replacement investments are sold.

Sales to third parties generally are taxable as capital gains.

This blog was shared with you by our friends at NCEO. For more great information on Employee Stock Ownership Plan and/or how to get started please visit NCEO.org.

 

Topics: Employee Ownership, esop

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