For business owners considering their exit, employee ownership could be one of several options on the table.
The most common way of pursuing a sale to employees is through an employee stock ownership plan (ESOP), a business model and type of employer-funded retirement plan often touted for its win-win tax benefits and as a tool for culture building and talent attraction and retention.
This structure has grown in popularity in recent years, with the number of employee stock ownership plans in Wisconsin increasing 30% from 173 in 2012 to 225 in 2022, according to data from the U.S. Department of Labor.
Simply put, in the case of an ownership transfer, an ESOP allows an owner to sell some or all of the company to its employees, who then accrue shares of company stock over time to be paid out upon exiting or retirement. The company buys out the departing owner at a fair market price, using either tax-deductible cash contributions or, in most cases, borrowed funds.
While the ESOP route as a succession strategy has proven successful for many, it’s not a fit for every company. Businesses weighing this option should consider the financial implications of both the initial transition process and long-term operations under the ESOP model.
Approaching the sale
At minimum, a company must be profitable before even considering transitioning to an ESOP. The National Center for Employee Ownership points out that the company should be “generating enough cash to buy the shares, conduct its normal business, and make necessary reinvestments.”
A good rule of thumb is at least $2 million in annual earnings and/or at least 25 employees, said Tom Venner, vice president and shareholder of Milwaukee-based investment banking firm Taureau Group.
“If you’re any smaller than that, it’s probably not going to make a lot of financial sense to do it yourself,” said Venner. For smaller companies, he noted a lower-cost alternative: selling to an existing ESOP – rather than creating one internally.
Not unlike selling to a third party, the process of forming an ESOP can be complex and expensive, said Venner, ranging in some cases from $150,000 to as much as $700,000.
Much of the initial cost is made up of fees for attorneys, accountants, appraisers and other advisors involved in the process as well as for the ESOP trustee – either an individual employed by the company or an outside firm – who is appointed to represent the employees’ best interest.
A business valuation is critical – and legally required – during the ESOP formation process and on an annual basis once the ESOP is formed. An independent valuation firm will conduct an analysis of the company’s financial statements, examining key metrics like revenue, profitability and cost structures, to determine the fair market value of the business and, in turn, the company stock price.
From there, the owner and ESOP trustee can negotiate the sale price and other terms of the transaction based on the value of the business.
When it comes to financing the transaction itself, one option – though rare – is the “pay-as-you-go strategy,” said Venner, noting an example of a client that sold 10% of the business to the ESOP each year for 10 years until it was 100% employee-owned.
“That just allowed them to finance it through the cash flow of the business, it just took a little bit longer than doing it all at once,” said Venner.
It’s more common for a company to take out a loan from a bank and then reloan that money to the ESOP, which can then purchase up to 100% of shares from the departing owner. As the ESOP pays back the company over time, shares are gradually released to employees on an annual basis.
Some banks specialize in ESOP lending, but they tend to be expensive, says Venner, noting the best route is usually a standard local commercial bank.
“Bankers do get a little bit nervous, especially if they don’t completely understand the process, though if you find a solid local bank that has financed an ESOP before or maybe has ESOP clients, that’s probably the best way to go,” he said.
Keeping up with compliance, repurchase obligation
Once the transaction is closed and the ESOP model is in place, the company’s day-to-day operations – and in some cases, leadership – remain the same. But under the hood, the business must adjust to a new financial structure and everything that comes along with it.
Like a 401(k), an ESOP is a qualified retirement plan that must meet certain regulatory requirements of the IRS and Department of Labor. Among them is an annual business valuation by an independent appraiser.
Beyond fulfilling the legal requirement, valuing the company on an annual basis determines the updated price of the company’s stock, giving employees a complete picture of “what their stake in the business is worth,” said Craig Olinger, managing partner at Waukesha-based valuation firm ESI Equity.
ESI works as a “partner” with its ESOP clients in helping them understand what produces the company’s value and why it fluctuates.
“We explain, both in good times and in bad, what’s driving the value, what’s making it go up – it could be profitability, the balance sheet is strengthening – and vice versa, sometimes company values just go down because … a lot of times there are external factors that are beyond management or a company’s control and they’re just at the will of the broader economy,” said Olinger.
Either way, ESOP employees have a unique, front-row seat to the financial health of the business because it’ll show up as a dollar figure on their annual statement.
The valuation also examines the company’s ability – and helps it plan – to fulfill its ongoing obligation to buy back shares from employees when they leave. This obligation can weigh heavily on a company’s cash flow, especially for mature ESOPs with long-tenured employees that have accrued numerous shares.
In the case of Oconomowoc-based Sentry Equipment – which transitioned to 100% employee ownership in 1986, with all shares allocated after 2012 – the repurchase obligation meant buying out 65 of its 200 employees over the past 15 years as a wave of baby boomers retired.
“We were able to do it with our ongoing earnings but in some years, it would be half of our earnings,” said Brian Baker, president and CEO of Sentry. “And then we have investments we have to make in the business and debt we have to pay off, so we didn’t have a lot left.”
Granted, there’s flexibility in the timing of payment distributions; for example, Sentry’s ESOP structure gives it five years to pay out former employees.
“I think of it as making the ship a little easier to steer,” said Baker.
Still, the repurchase obligation is something companies “absolutely have to plan for,” he added.
A key piece of that planning is constantly forecasting employee turnover, including termination and retirement, the amount of shares the company will need to buy back and the future price of those shares.
Between the regulatory compliance and repurchase obligation forecasts, the internal management team has a lot to keep track of – and that’s where the guidance of an outside advisor can come in handy, said Olinger, who works with Sentry Equipment as one of ESI’s clients.
“When someone is doing ESOP advisory on a daily basis and they see 60 or 70 or maybe even a couple hundred firms that they work with on an annual basis,” Olinger said, “you can really get best practices together and say, ‘hey, it looks like you guys are headed down this route, have you thought about doing this because we’ve seen this work better in the past.’”
