Thinking of Selling Your Business? Make Sure to Consider an ESOP

Sale vs. ESOP

Business owners, in the context of today’s strong M&A market, enjoy a wide range of strategic options as they consider the future of their companies. The final decision as to which alternative to pursue should be driven by the owner’s individual transaction criteria and specific characteristics of the business. Transaction criteria include everything from maximizing cash proceeds at closing, making a clean break from managing the business and promoting employee participation in the management and ownership of the company.

The choice between an outright sale of the business and pursing an Employee Stock Ownership Plan (ESOP) often places the goal of maximizing closing cash at odds with promoting employee ownership. The specific characteristics of a business—for example, its cyclical nature or its CapEx demands—might ultimately impact this decision.

What are the Benefits of an ESOP Transaction?

Business owners often consider an ESOP transaction in an attempt to simultaneously reduce their tax burden from the sale and transfer ownership to a loyal group of managers and employees. In certain cases, an ESOP can deliver the seller a tax efficient outcome by using leverage (both from third-parties and seller-financing) to increase cash at closing. The amount of available debt for an ESOP transaction, as well as the possible loan terms (recourse vs. non-recourse debt, rate, covenants, etc.), depend on many factors including the operations of the business and credit market conditions.

Is an ESOP Right for You?

In today’s strong credit markets, opportunities exist even for relatively small businesses (those with an EBITDA of $10 million or less) to raise capital. For instance, a business with stable cash flows and modest capital requirements can often raise senior debt of more than three times the business’ most recent twelve months of EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). The business could then supplement this senior debt with some seller financing.

An ESOP structured with reasonable debt service and capital requirements can provide an opportunity for value creation for both the seller and new employee owners. It can also support the additional fees (audits, valuations, etc.) and redemption obligations associated with an ESOP.
Companies with lower EBITDA, highly cyclical or seasonal operations, and high cash flow demands for capital expenditures or working capital usually make poor ESOP candidates.

Companies with these characteristics tend not to be able to support much in the way of non-recourse debt. This, in turn, results in lower net cash proceeds at closing, and such companies may have difficulty meeting redemption regulations over time.

Advantages of Selling

In many instances, a partial or outright sale of a business can deliver better outcomes to the owner than can an ESOP transaction. A sale transaction affords the parties much more flexibility in addressing their goals than does an ESOP.

For example, the seller and buyer can structure the sale transaction as an asset sale, a stock sale, or perhaps even a hybrid sale (such as a stock sale that is treated as an asset sale). The parties can also defer transaction proceeds to manage the seller’s tax liabilities. In addition, a seller may roll some equity into the deal or provide debt financing if the seller desires to maintain some continued economic ties to the business after closing. Further, a sale transaction can be structured to provide the management and key employees of the business with an opportunity to buy or earn equity in the business through management incentive plans.

The current high public equity valuations and tremendous amounts of private equity capital awaiting deployment, coupled with strong credit market conditions, have driven private sale transaction multiples to near historic highs. These elevated transaction multiples and structuring flexibility allow partial or complete sale options to deliver higher proceeds at closing than ESOP transactions. They also offer the chance to provide similar benefits and incentives to the management and employees of the business.

Summary: Outright Sale vs. ESOP Transaction

The relative attractiveness of a sale or partial sale of a business compared to an ESOP depends upon a business owner’s overall transaction goals and objectives, as well as the operating characteristics and prospects of the business itself.

ESOP sales can provide attractive tax benefits and employee incentives, especially in larger, more stable businesses. Outright sale transactions generally offer sellers and buyers much greater flexibility in structuring transactions to meet specific objectives across all types and sizes of companies. Please talk to a Sikich professional to learn which choice would be best for you and your business.

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