Leaving a legacy: ESOPs are exit ramps with benefits

There are many ways to exit a business, some of which include complete or partial liquidation, or transfers of ownership via mergers and acquisitions, or through business brokers. One approach – establishing an employee stock ownership plan (or ESOP) – gives workers ownership interest in a company by way of stock shares. It is a strategy that is becoming more commonplace, as it addresses the changing goals of business owners and presents a value-preserving alternative to more traditional exits.

Advisors and other experts cite a variety of reasons for the increasing popularity of ESOPs. “We’re living in an era where so many things feel disposable,” says Lawrence Kaplan, founder and managing partner of CSG Partners in New York City. “A sense of purpose, community and legacy are becoming scarce commodities. Middle-market business owners increasingly want more than pure-play exits. Others are interested in partial liquidity events without having to sacrifice their companies’ independence. These are big reasons why we’re seeing a surge in employee stock ownership plan interest.”

For many, ESOPs provide a way to safeguard a business against the potential pitfalls of bringing in an outside buyer, notes Blake Head, managing director of the ESOP Advisory Group at BDO Capital Advisors. “What sets ESOPs apart from other exit strategies is their unique ability to benefit all stakeholders — the company, the employees and the selling shareholders,” he says. “It also removes the uncertainty of a third-party sale that may bring about changes in leadership, employment, benefits and potential relocation of the business in certain cases.”

Advisors say ESOPs can help a company retain its employees through an ownership transition. “ESOPs help to preserve legacies, allowing owners to maintain their company’s culture, values and continuity,” says Jeff Agranoff, chief human resources officer and HR consulting principal for Grassi Advisors in Jericho. “The employees become invested in the organization by becoming owners and are rewarded further for their longevity and commitment.”

Pursuing ESOPs can offer owners considerable control over how their company’s equity is divided. “There are different ways to allocate shares to employees, and owners have the discretion on the formulas used to allocate shares in the design of the ESOP, subject to passing compliance testing,” says Head.

The flexibility of how ESOPs can be structured also makes them an attractive option to businesses making partial exits, or owners who want to retain some equity. “Business owners maintain significant control over the division of ownership in an ESOP,” says Agranoff. “Owners can sell any percentage of the company to the ESOP, from a minority stake to 100%, allowing for a phased approach. Also, owners often remain in leadership roles, maintaining operational control even after selling to the ESOP, as well as selecting their succession team.”

In other instances, when paired with trusts, certain types of plans can facilitate the transfer of company ownership with minimal tax liabilities. “Leveraged ESOPs — where companies borrow money on their employees’ behalf and sell stock to a trust at fair market value — fit a number of use cases,” explains Kaplan. “These can be powerful, tax-advantaged strategies for family businesses seeking generational transfers and private companies with owners who either want to partially diversify or depart altogether and hand the reins to their management teams.”

ESOPs can also facilitate other plans for dividing equity to be established. “In some instances, companies might create a separate pool of synthetic equity, which is governed by the company’s board of directors,” Head explains. “Since this synthetic equity is not a part of the tax qualified plan (the ESOP), the board has the discretion to direct these awards to key leaders in the company. This allows companies to attract and retain top talent by providing incentives in addition to their participation in the ESOP.”

Many advisors believe that ESOPs will continue to grow in popularity in regions with a strong small and medium-sized business presence.

“ESOPs offer an attractive succession solution as baby boomer owners approach retirement,” says Agranoff, “and growing understanding of ESOP benefits among business owners and advisors drives adoption. As more ESOPs succeed, particularly in diverse industries, they inspire other owners to consider this option.”