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The ESOP Exit Strategy: Benefits, Implementation, and Sale Options

As a small business owner, planning for the future of your business can be daunting. You’ve poured your heart and soul into building your business, and the thought of one day stepping away can be overwhelming. Who will carry on your legacy? How will you get a fair price for your life’s work? An Employee Stock Ownership Plan (ESOPs) is one exit strategy that can benefit both you and your employees.

But what exactly is an ESOP, and how does it work? More importantly, can an ESOP-owned business be sold to a third party? In this article, we'll explore the answers to these questions, delve into the process of selling an ESOP company, and discuss the considerations for different business structures when establishing an ESOP.

What Is an ESOP?

Considered to be among the most tax-efficient methods of employee ownership, an ESOP, short for Employee Stock Ownership Plan, is a type of qualified retirement benefit plan that grants employees ownership interest in the company they work for.

As the name implies, through an ESOP arrangement, workers' ownership interest is not with individual company assets, but as shares of the company’s stocks.

Under an ESOP plan, employees become employee-owners.

While ESOPs are most commonly used by C corporations, they can also be adopted by S corporations, limited liability companies (LLCs), and professional corporations (PCs), albeit with some limitations and additional requirements.

The latest data from the National Center of Employee Ownership shows approximately 6,467 ESOPs in the United States. These ESOPs hold assets valued at more than $1.6 trillion and are spread out across all industries.

However, the industries with the highest number of ESOPs include professional services, manufacturing, and construction, at 21%, 20%, and 15% respectively.

Business owners who want to cash out their investments, but are worried about finding a ready market when that time comes may want to consider selling their companies to an ESOP.

Other types of employee ownership plans include:

• Worker cooperatives
• Employee ownership trusts
• Equity grants, like direct purchase programs, and stock option plans

How Do ESOPs Work?

In an ESOP arrangement, workers don’t directly purchase a company’s stock.

Instead, the company first creates an ESOP trust fund company.

Typically, trust companies are legal entities that act as fiduciary agents on behalf of specified persons.

With ESOP trusts, the aim is to purchase the company’s shares on behalf of the ESOP participants.

How ESOP Trusts Are Financed

A company may make financial allocations to an ESOP trust:

• To fund issuing new shares to eligible employees
• To enable the trust to buy shares from existing owners
• To clear any debt the ESOP trust may have incurred to finance the purchase of shares of existing owners

📢 It’s crucial to note that plan participants rarely pay any amount to the ESOP trust.

How ESOP Trusts Are Operated

Once the ESOP trust is set up, it allocates shares to employee accounts through a process known as vesting.

There are two types of vesting.

• Cliff vesting: Employees are not entitled to any benefits before a specified length of service, then they are entitled to 100% benefits after that service is completed.
• Graded vesting: The percentage of benefits an employee can access is incremental over a period.

If an employee leaves the company, what happens to their shares depends on whether they were vested.

Unvested shares are typically forfeited back to the company upon leaving.

Vested shares are distributed and owned by the employees when they leave. At which point they can:

• Sell the ESOP shares back to the company
• Hold on to the shares
• Rollover the shares to a qualified retirement account like an IRA for capital gains tax advantages

How Do ESOPs Benefit Employees?

ESOPs are a type of employee benefit plan. The advantage of ESOPs over other types of retirement plans, including 401(K), is the fact employees don't have to contribute a dime for their benefits as the company makes all the contributions.

Employees generally don’t pay income tax on the contributions made by the company on their behalf. Also, ESOPs are an excellent motivational tool for employees because they often feel like they have an ownership stake in the company, so they have a vested interest in it succeeding.

How Do ESOPs Benefit Business Owners?

As mentioned, ESOPs are an excellent way to cash out investment in a closely held company.

Besides guaranteeing a ready market, ESOPs offer selling owners the opportunity to hand over the company to those with the same aspirations.

ESOPs can come in handy when doing exit or succession planning.

ESOPs address legacy concerns that owners usually worry about, including the fear that new owners may move the business or change its course, brand, or focus.

Can You Sell an ESOP Company?

Yes, an ESOP-owned company can be sold to a third party, but the process is more complex than a traditional business sale.

Initiating the Sale Process

To begin the sale process, the ESOP trustee, employees, and Board of Directors must first approve the decision to sell the company. This ensures that all stakeholders are in agreement and that the sale aligns with the company's goals and the interests of the employee-owners.

Valuation and Fairness Opinion

Once the decision to sell is made, a financial professional will need to provide a fairness opinion on the sale price. This step is crucial to ensure that the ESOP participants receive a fair deal for their ownership stake. The fairness opinion takes into account factors such as the company's financial performance, market conditions, and the terms of the sale.

Employee Vote

Depending on the structure of the ESOP and the terms of the sale, the employee-owners may need to vote on whether to approve the sale. This step is necessary to ensure that the majority of the employee-owners are in favor of the sale and that their interests are being considered.

Distribution of Proceeds

Once the deal closes, the ESOP will be terminated, and the cash proceeds from the sale will be distributed to the participants. The distribution of proceeds will be based on each participant's vested ownership stake in the company. Participants may have the option to reinvest their funds or take a cash distribution, which may have tax implications.

Third-Party Buyers

Potential third-party buyers for ESOP companies include private equity firms, strategic buyers in the same industry, and other ESOP companies. Each type of buyer may have different motivations and considerations when acquiring an ESOP company. For example, private equity firms may be interested in the company's growth potential and profitability, while strategic buyers may be looking to expand their market share or acquire new technologies. When selling to another ESOP company, there may be additional considerations around merging the two ESOPs and ensuring that the interests of both sets of employee-owners are protected.

While selling an ESOP company to a third party is possible, it requires careful planning and consideration of the unique aspects of ESOPs. By involving all stakeholders, obtaining a fairness opinion, and ensuring that the interests of the employee-owners are protected, an ESOP company can successfully navigate the sale process and achieve a positive outcome for all parties involved.

To learn more about how to sell a business and all the options you have, visit the BizBuySell Learning Center. 

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