How a Small Company Lives On After Its Founder Retires and Cashes Out
By Martin Staubus
If you’re an entrepreneur, you’re just a bit different from many other people. You have a certain drive that is distinctive. You commit your best efforts to building a business – a challenge you pursue with passion. It isn’t easy. You make a lot of sacrifices and difficult compromises with your family. But, as you mature and look back at the company you’ve created, you find something to take real pride and satisfaction in.
So what happens to this business – this creation that you’ve brought into being – when you’re ready to retire? What will become of this enterprise? Will you leave a lasting legacy that brings meaningful benefits to others that you care about? Or will you just shut the doors or sell it off to a buyer who will likely chop it up, take out the parts they want and discard the rest?
There is another option. It’s a path that enables an entrepreneur to gain an attractive financial return while also creating a powerful and enduring legacy – an opportunity to “do well, while doing good.” The concept involves the sale of your company to your employees, through a structured process known as an employee stock ownership plan, or ESOP.
How You Can “Cash Out” Without Destroying What You Have Built
Technically, an ESOP is a “qualified retirement plan,” similar in some ways to a 401k plan. Qualified retirement plans, as the name suggests, “qualify” for some very attractive tax advantages. An ESOP, then, is a qualified retirement plan that is expressly intended to be used for the purpose of acquiring stock of the sponsoring company. One of the great things about this is that an ESOP can borrow money from a bank or other lender and then use that money to purchase company stock from the owner. It’s what the Wall Street finance types call a “leveraged buyout,” but in this case done on behalf of the company’s employees. Stock that is purchased by an ESOP is put into the personal retirement accounts of the employees.
Lots to Like about ESOPs
Business owners who learn the details about ESOPs are simply amazed that such a great thing exists.
Here is short run-down of what there is to like:
Tax savings. The tax rules for ESOPs provide benefits seemingly at every turn. First, the company itself will be able to claim a deduction for the entire price that the ESOP pays when it buys stock from an owner (this deductible amount is spread over the years that the ESOP is repaying the loan it took out to buy the stock). Second, the selling owner can avoid the capital gains taxes that would normally be due on the sale of the stock. Third, the employees gain a valuable (and highly incentivizing) stake in company ownership, with all the income taxes they would normally pay if awarded company stock deferred until they retire and cash out of the plan. All told, the taxes saved on a sale to an ESOP actually exceed the value of the stock being sold! So, for example, if an owner sells $10 million of his stock to an ESOP, that transaction will generate about $10.5 million of tax savings (depending on which state you’re in), spread among the company, the owner personally, and the employees.
Flexibility. One of the things that owners like best about the ESOP is that they don’t have to deal with an adversarial buyer, as they would if they tried to sell their company through the conventional “mergers & acquisitions” route. So there is no one you have to negotiate with. As the owner, you simply decide when you’d like to do this, how much stock you would like to sell at this time, how the ESOP’s purchase should be financed, and much more. And once you’ve made those decisions, you simply put the process into motion.
Exiting on Your Own Schedule. A key form of flexibility with an ESOP is that the business owner can sell any portion of the ownership that he or she wishes. It’s certainly possible to sell the entire company in a single transaction via an ESOP. But then, there are other options if you just want to unload the whole business. What’s harder to do – but easy with an ESOP – is to sell just a portion of your ownership. Consider this scenario. A business owner sets up an ESOP, to which he sells 25% or 50% or whatever portion he wishes of his company. This allows him to accomplish two powerful goals. First, he has taken some of his illiquid, undiversified equity value off the table and turned it over to a good wealth manager, thereby assuring economic security for his family regardless what might happen to the business. Second, he has created a powerful employee incentive program. With the employees now having a clear stake in the company’s successful operation, the owner can ease back on his work hours, delegating more responsibility to others and trusting them to a greater degree to “mind the store.” Now the owner can enjoy some vacation travel without the worry, or simply play more golf, or begin to pay back the time that he owes to his family, who didn’t get enough of his time in the early years of the business. And later, when the time is right, he can sell more stock –even the entire remaining interest – to the employees via the ESOP.
Price. The key issue in any sale – price – is settled very simply. The ESOP laws require that a professional business appraiser be engaged to study the company and then provide an expert opinion as to the fair market value of the company. The sale can then be conducted based on that price. You don’t have to worry about a buyer who waits until the last moment in negotiations and then tries to beat you down on the price.
Employee engagement. There are countless anecdotal examples about employees being more engaged and excited than ever. More importantly, academic studies have also shown significantly higher levels of employee engagement. When employees own a stake in the business, they take their work more seriously, they work smarter and more carefully, and the result is a marked improvement in business results. Operating the business becomes a true team sport, with everyone working from the same scoreboard. Owners report that it is a deeply gratifying experience to be a leader in an environment where the employees truly want the company to succeed.
The Legacy You Will Leave
Who buys a business when an owner is ready to sell? Traditionally, it is a much larger organization – whether a big player in the same industry, a related industry, or a private equity firm. They buyer is probably not local, maybe even based out of state. What is the result? Employees are going to lose jobs; the company name is going to come down off the wall. The buyer is going to shred the company into pieces, ending the existence of the enterprise that the founder spent a lifetime building. There’s more. All the vendors and service providers who served the company lose business. The company’s business attorney, insurance broker, CPA – all these providers take a hit. The city and county may lose tax revenue. The sale leaves a hole – a little crater – in the economic base of the community.
Not so when the company is sold to the employees via an ESOP. The company continues on as an independent business. The name stays on the wall, the local suppliers and business advisors continue to serve the firm. As for the employees, of course they keep their jobs. But they gain much more than that. They experience the opportunity to own a piece of a thriving business. If they work hard and work smart, they can continue to grow the business, building wealth that will bring economic security to themselves and their families. They will learn what it takes to operate a business successfully, and become smarter and more sophisticated in the process. For many employees this becomes a life-changing experience.
Through a tax-free sale to the employees, that’s the legacy that a business owner can leave. Doing good while doing well.
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Martin Staubus is the executive director of the Beyster Institute, part of the Rady School of Management at UC San Diego, where he teaches and advises business leaders on the development of stronger companies, especially through the practice of employee stock ownership. Martin has 30 years of experience in business, having served in varied roles as an attorney, consultant, Labor Department policy advisor, corporate executive and corporate director. He has served as Associate Director of the ESOP Association in Washington DC, and as a director of the National Center for Employee Ownership. If you would like to get in touch with Martin, he can be reached at [email protected]