September 19, 2017 | Patrick McFarlen
In this series of articles, EKS&H Consulting Partner Patrick McFarlen explores the personal and business considerations involved in a successful business transition. In this article, he discusses the unique decisions and challenges related to employee stock option plans (ESOPs) and management buyouts (MBOs).
While family succession is a common avenue for small business ownership transition, it’s impossible (or maybe just remiss) to talk about business succession without talking about ESOPs and MBOs. In both these scenarios, ownership is transferred from the current leadership to a group of executives or employees. ESOPs and MBOs have been a popular business transition option for a long time, and ESOPs became even more so after 1996 when a legislative change expanded their entity type from C corporations to (tax-free) S corporations. Today, it’s estimated that 70% to 80% of ESOP installations since then have been in S corporations, and the 7,000 ESOPs in the U.S. involve more than 14 million participants.
ESOPs and MBOs are particularly attractive options when strategic buyers are unavailable or uninterested, and financial buyers (e.g., private equity) have sales, strategic, or operational plans that would be difficult to meet. Several studies have found ESOP companies outperform their non-ESOP counterparts (by 2% to 3% per year), are more stable, and offer greater retirement benefits.
Regardless of the reason behind choosing an ESOP or MBO, there is a recurring truth to all business succession planning: the more time to plan for your succession, the better. Let’s consider two recent business transitions of this variety:
We recently worked with the owner of a closely held manufacturing company. The second generation was uninterested, and neither strategic nor financial buyers were an option. After meeting potential management/owners, it quickly became clear they lacked the understanding and acumen to successfully run a business. We recommended a stock appreciation rights (SAR) plan, which occurs over time and creates value the employees use to buy company shares. This approach both incentivizes employees and provides necessary time to get up to speed.
While more time planning your transition means more options when the time comes, our second example illustrates how quickly ESOPs can sometimes be achieved. This client, a construction company owner, wanted to complete a 100% ESOP S corporation, in part to minimize the company’s tax obligation (a 30% to 40% cost advantage over competitors). The client came to us in March and assembled a team of advisors representing both the interests of the owner and the interests of the employees. About four months later, the ESOP was complete. In this case, employees were prepared and capable of taking on the responsibilities of running the company, which allowed for the fast turnaround.
Financing is another important component when considering an ESOP or MBO for your business transition (according to the ESOP Association, approximately 70% of ESOPs are leveraged.) Financing is usually substantial and is often provided using a combination of debt and equity derived from buyers, lenders, financiers, and sometimes sellers. A leveraged ESOP borrows money based on the credit of the employer or related companies. While loans can be made to the ESOP itself, lenders typically prefer to loan to the employer (due to the business’s assets), and then the company re-lends the money to the ESOP. A comprehensive financial analysis should identify and factor in cash flow, sales, profitability, debt capacity, and growth potential.
Whether considering employee or management interest and preparedness to own, or the technical elements of deal financing, it might be helpful to utilize the “five questions” model to determine if one of these business transition options is right for you. For example:
Choosing the right business transition plan can be a difficult and complicated proposition, and achieving success typically requires working with a team of advisors experienced in a wide variety of options. Considering the questions above, and others, is an important early step in the process and can help owners quickly narrow down which options will best meet their goals.
Part four of this series will explore some of the questions and considerations around a sale to a strategic buyer or financial buyer.