Exit Strategies Using ESOPs

Successful entrepreneurs know that it takes time and planning to maximize the value of their companies’ stock when they are ready to move on.

Developing an exit strategy is not an easy process, but it is a process that can unfold gradually. It takes time to position a company’s financial health, identify successor management and decide how and to whom you will sell your business when you are ready to leave.

Part of the transition planning process is deciding on which transition method makes sense for you, from a financial, corporate and employee perspective. There are many options, each with its own benefits and limitations. Some of you may choose to sell the company to an outside buyer, cashing out completely and walking away from the business in one clean transaction. For family-owned businesses, you may opt to “gift” your ownership interests to a relative. Some owners simply wind down the business and turn out the lights.

But, there is another alternative that you might not have considered-an “internal” sale that can be structured using an employee stock ownership plan or ESOP. In the right circumstances, the ESOP is the most controlled and tax-efficient buyout technique available.

How can a business like yours harness the power of ESOPs to accomplish liquidity and business succession goals? Much of the information that follows applies to privately-held companies across industries. But there are several issues unique to construction companies to consider before implementing an ESOP.

ESOPs Defined

ESOPs are widely misunderstood by business owners and financial professionals alike. By definition, ESOP is simply an acronym for an “employee stock ownership plan” (not stock option plan). ESOPs are company-sponsored, tax-qualified, retirement benefit plans. They are a type of defined contribution plan, much like profit sharing and 401(k) plans, so many of the rules that govern those plans also govern ESOPs. There is, however, an important difference. While other defined contribution plans are required to own stock in many (mostly publicly-owned) companies, an ESOP is required to own one stock in its portfolio, the stock of the company. In addition to being required to own only company stock, the ESOP is also allowed to borrow money to purchase shares of that stock. These defining characteristics (ownership of company stock and the ability to borrow) are the cornerstones of the ESOP’s ability to provide a mechanism for a sale of the company that does not require an outside buyer.

Ownership and Control in an ESOP Company

ESOPs afford business owners the ability to sell part or all of their stock at a fair price. They offer liquidity that business owners desire, but in essence, they keep the companies owned by the people that helped create them. In addition, because of the way stock is held in an ESOP, a certain degree of control can also be maintained.

The name “ESOP” suggests that employees own the stock directly, yet this is not true.  The assumption that employees own the stock in these plans is perhaps the biggest misperception of ESOPs. Whether a company has 50 or 5,000 employees, stock purchased by an ESOP is held by a single shareholder-the Employee Stock Ownership Trust. Employees earn a beneficial right to receive stock over time, but never own the shares directly. This is true for the Home Depot ESOP as it is for a small, private contractor. As part of the transaction process, an ESOP trust is created (to purchase and hold the stock), and trustees are named by the board of directors of the company. It is very common for companies to hire an independent trustee to approve the purchase of stock from a seller and then to appoint an inside trustee for ongoing administration of the plan.

This strategy effectively allows owners to begin a financial transition in their business by selling stock on a gradual basis, while remaining involved in their companies for a period.

This is why we say that the ESOP is a “controlled” buyer of stock. First, by establishing an ESOP, the company creates an internal buyer for company stock without having to search for a third party buyer. Second, the exact percentage of stock being sold is determined by the seller and will be a function of the company’s ability to pay for the stock while the business continues to operate. And finally, maintaining control of the ESOP shares can be accomplished by selecting a prudent, independent trustee, who provides an impartial perspective on the transaction.

The Tax Efficiency of ESOPs

The ESOP is an economical buyer of company stock because tax deductions are available for the transaction costs related to buying the stock-even when the money is borrowed to make the purchase. This is quite different from an inside sale to management or an outside sale to a third party where the costs of the transaction are paid with after-tax cash.

The following table illustrates this difference. The example assumes a purchase price for stock of $2.7 million. The illustration shows a typical commercial loan (where the interest expense is tax deductible but the principal repayments are not) and a loan used in an ESOP transaction (where both interest and principal are tax deductible).

You can see that if a non-ESOP buyer paid $2.7 million for your business, that buyer would be required to generate $3.0 million in profits (do we need to know over what period of time the profits should be generated?) to recover the transaction costs. The ESOP sale (sale to whom, the ESOP?  Is the ESOP business then sold-this is a little confusing to me, but perhaps the heading with help explain this), however, requires only $2.1 million of profits to pay for the same stock. This means that the ESOP can either finance a larger buyout (buyout of what, the same business?) with the same cash flow, or use less cash for the same buyout.

Assuming a loan amount of $2.7 million, the company spends $945,000 less in cash in the ESOP transaction to repay the same debt. This is $945,000 that is available for working capital and growth. This is also $945,000 the company would not have available in a sale to a non-ESOP buyer. There are limits on the available deductions in any given year for an ESOP (similar to the limits for other defined contribution benefit plans). But regardless of the repayment terms on the loan used for the ESOP transaction, the deductions are available for each payment.

To expand on the notion of the ESOP being the most “tax efficient” transaction, here are two other transaction realities. First, sellers in certain ESOP transactions are permitted to defer indefinitely the payment of capital gains taxes on the stock sale if certain conditions are met. Sell your stock and keep all the proceeds? Let’s use the $2.7 million transaction illustrated above and assume a basis in the stock of $100,000. (What does basis mean?) The company borrows the funds and the loan proceeds are used to purchase the stock. As long as the ESOP owns at least 30 percent of the company stock (one of the requirements) then the seller is eligible to defer as much as $390,000 in taxes by taking the proceeds and re-investing them in the market.

This technique is similar to a “1031 property exchange,” (might need to define 1031 property exchange) but in an ESOP sale, the seller has twelve months to use the sale proceeds to purchase qualifying U.S. stocks or bonds. Section 1042 of the Internal Revenue Code defines qualified replacement property (QRP). As long as the proceeds are invested in QRP, the seller defers capital gains tax. One of the other requirements of this deferral is that the ESOP company must be a C-corporation, so S-corporation sellers will not be entitled to the same deferral. (But S-corporation owners should not feel left out, as there is a dramatic tax advantage provided for these companies as well, described below.)

In our example, the $2.7 million ESOP transaction created tax savings for both the seller and the company, as much as $1,335,000, thus supporting the claim that the ESOP is tax efficient.

S-Corporation ESOPs

Even though sellers of stock in S-corporation ESOP transactions are required to pay the capital gains taxes on the sale of their stock to an ESOP (on the price less accumulated basis, of course), the S-corporation ESOP has a significant advantage the C-corporation ESOP does not. Only S-corporations can take advantage of a tax reality that results in the company paying zero federal corporate taxes. How? Because the company is owned by a non-taxpaying shareholder-the ESOP.

Recall that S-corporations, as business entities, do not pay federal taxes. Rather, any corporate earnings are “passed through” to the company’s shareholders in accordance with their ownership, and the shareholders individually pay any taxes due. Remember that the ESOP itself is a tax-exempt trust for the benefit of employees. Any S-corporation shares owned by the ESOP are not subject to taxation (either at the federal or state level). The more S-corporation stock that is owned by the ESOP, the less tax is due and the more cash is available for repayment of the buyout or for corporate growth. 

Many companies have responded to these incentives. The ESOP Association, a Washington, DC-based non-profit organization, estimates that 35 percent of all ESOPs are now S-corporations and 2,000 are 100 percent ESOP-owned. This is a stark comparison to 1998, the first year ESOPs could be shareholders of an S-corporation, when there were no S-corporation ESOPs and only 15 percent of ESOPs in the United States were majority owned by the plan. Clearly, the advantage created by this legislation has had its intended effect of increasing the number of ESOPs.

In a properly structured transaction, an owner could sell stock to an ESOP in a C-corporation and take advantage of the indefinite capital gains tax deferral. Following the sale, the company could then make an S-corporation election and take advantage of the S-corporation ESOP tax reduction.

The tax benefits of an S-corporation ESOP transaction go beyond the benefits to the company and the seller and also help the employees. As a result of the transaction, the company’s tax burdens are reduced, enabling the company to pay for stock purchases faster and offer the ability to reinvest in the company at a more rapid rate. This ultimately leads to a company and ESOP that are better positioned to buy another block of stock from or a company that has extra cash to reinvest in the business.

ESOPs and Construction Companies

If ESOPs are so great, why are there not more of them? That’s a great question. One important reality facing contractors with an interest in using an ESOP is the effect of leverage and bonding capacity.

Sureties may reduce the bonding capacity for contractors with debt because of the fixed costs associated with debt repayment, the balance sheet accounting for leveraged ESOPs and their seniority of claims. To the extent a contractor commits cash flow for a fixed period of time, the volatility of a given cash flow increases. If a project goes bad, there is less cash flow available to correct the problem in the sureties’ eyes. When ESOPs are proposed to sureties, the best results come when only a small portion of free cash flow is being used to finance the ESOP. This means that it will take somewhat longer for a contractor to sell shares to an ESOP than to a third party. If the owner has already decided they want “out,” a longer payout ESOP may not be of interest.

Another factor relates to the sureties’ focus on net worth ratios. The accounting for leveraged ESOPs hits the right side of a company’s balance sheet only by increasing the liabilities and reducing equity. The magnitude of these charges is directly related to the transaction size. Thus, if the ESOP sale is a smaller amount, it is easier for the balance sheet to absorb these changes.

Finally, because banks are “senior” lenders, they typically get a “first priority” on all assets in the event of liquidation. This makes sureties uneasy since they are left only with certain assets once the bank is done securing its repayment.

For those with bonding requirements, there are a couple of considerations for using leveraged ESOPs:

1. Use leverage in small amounts, or simply sell stock to the ESOP on a year-to-year basis without any debt.
2. If the owner personally guaranties the bonds, the net worth accounting issue can be managed because the reduction in company net worth will be offset by an increase in the owner’s personal net worth.

Other attributes that make companies good ESOP candidates-from the perspective of the appraiser, the banker and the surety-are management depth, customer and project concentrations and growth rate.

Alternative Transaction and Compensation Methods

ESOPs are quite compatible with other transition strategies and do not have to be used independently. One growing opportunity in the market is private equity interest in the ESOP technique. Here investors provide funding, along with banks, in “low leveraged buyouts.” The outcome is this: companies without as much debt but whose returns are shared with the investors.

We have often heard business owners tell us that they want key managers to have the chance to earn or buy more than their ESOP account. For this reason, it is quite common to combine the ESOP with a management incentive plan or buy-in (do we need an example of what this might be?) so the next generation of leaders has an opportunity to benefit from their growth of the business. Some business owners believe that people care more about something they have purchased, and they are concerned that the ESOP provides only something given by the company. For these clients, we create a structure where managers buy in to the deal.

Another approach is to create a performance-based award, where selected managers earn equity only if the appreciation in a given year exceeds certain targets. Often stock appreciation rights are used as the award since they are easy to understand and calculate. Stock appreciation rights become valuable only as the stock price rises, so value is still being accrued by everyone, though in differing proportions.

Valuation

Valuation is another topic that warrants discussion when considering transition strategies.  The nature of construction businesses limits the valuations for most privately-held, middle market contractors. Even the roll-up craze in the late 1990s that disputed conventional rules of thumb for valuing contractors ultimately proved not to be the bellwether some anticipated.

Perhaps the most important valuation principle to remember is that a given share of stock can have different values depending on the reason for the appraisal. A share of stock is worth more in a public offering, for example, than it is in an ESOP. A share of stock for a buy/sell agreement may have a lower value than the ESOP. A sale of all of the company will certainly have a greater value than a sale of less than a controlling interest. I’ve heard business owners say a dozen times, “I got an offer for my business at $5 million, so I want $5 million in the ESOP.” Assuming the offer is bona fide, this makes all the sense in the world-until the owner tells me that he wants to sell only 30 percent of the company. Because one offer is for a controlling interest (usually >51 percent) and the other is for less, the price in the latter should be lower.

Fundamentally, every valuation has to consider the percentage of stock being sold along with the characteristics of the situation that affect the marketability of the shares and the liquidity of the company offering the shares. For contractors, a rule of thumb for valuations is “book value.” This rule of thumb has many weaknesses and is more applicable to some contractors than others, but it can provide a good starting point for determining a company’s value.

Another major factor for valuation is the sustainable level of profitability. Appraisers will end up relying mostly on several earnings valuation methods to arrive at a share’s value, so profitability is the most important determinant of value. Typically, after the earnings methods have been calculated, the appraiser will compare those results to book value to see how they relate. If the earnings values are within a multiple range of book value, then the earnings estimate is probably a good one.

For the right companies, using an ESOP as the whole or as a part of a transition strategy offers a degree of tax efficiency, control and flexibility not found elsewhere. While we advise most contractors to use ESOPs to buy a part of their stock, they retain the option to sell the remainder of the business later to the ESOP or to any other buyer.

At the end of the day, the ESOP can be an excellent transition tool for a privately-held construction company in the right situation. For contractors seeking a gradual business transition in a tax efficient and controlled manner, an ESOP could very well be right for you.
 

Construction Business Owner, April 2007