Aesop … ESOP? This Succession Tool is No Fable
The Power of a Minority Interest ESOP in an Exit Strategy
By Michael Kenneth
Aesop was a slave and storyteller who is believed to have lived in ancient Greece. His celebrated Aesop’s Fables is a collection of tales that cover ethical aspects of life for both children and adults. But the real fable could be Aesop himself. Though his fables survive, there is some doubt about his actual existence.
Aesop is connected to hundreds of quotes and aphorisms, including some that relate to planning and preparing for the future. Consider these:
It is one thing to conceive a good plan, and another to execute it.
It is thrifty to prepare today for wants of tomorrow.
Interestingly, Aesop’s thoughts relate to a financial tool of a similar name—ESOP (Employee Stock Ownership Plan). ESOPs—and particularly minority interest ESOPs—can provide business owners with a clear path to fulfilling a well-planned exit strategy and preserving some of today’s earnings for use in the future.
Let’s take a closer look.
ESOPs Defined
As its name suggests, an ESOP provides employees an ownership stake in a company, but with the benefit of a valuable tax exemption. A minority interest ESOP allows an owner to sell a partial interest in his or her company as the beginning of an exit strategy, while still maintaining control of the business.
An ESOP is established as a trust, which owns the company shares, and is managed by a trustee on behalf of employees. However, the trustee is not involved in management of the company.
In a leveraged ESOP, the trust purchases shares of the company from the owner using financing it has obtained either directly or, more commonly, through the company on behalf of the trust. When the company sponsors the financing, it agrees to make contributions to the ESOP that enable repayment of the loan. The contributions are tax deductible, yielding a tangible financial benefit.
Employees become minority shareholders. Participation requires no cash outlay, and their company stock accumulates and grows tax deferred. They realize their gain by selling their shares back to the company when they leave or retire.
The Benefits of Minority Interest ESOPS
A minority interest ESOP provides a host of benefits for an owner and company employees.
First, it allows an owner to monetize a portion of a lifelong investment in an enterprise while maintaining control and still having the opportunity to monetize the remaining majority investment at a potentially greater return in the future.
This is called having a second bite at the apple, with the implication that the business will grow larger and juicier after first bite. From the family business perspective, it’s a strategy that breeds generational wealth and continuation of the family legacy.
A minority interest ESOP also solves the issue of finding a buyer, especially a buyer that is interested in maintaining the corporate culture and extending the growth trajectory. There may be significant interest from potential strategic buyers or private equity groups, but those types of buyers often have different motivations, such as combining operations under the umbrella of their competing business, rebranding, or acquiring the business for certain assets and shedding operations they deem non-essential.
In short, all buyers are not the same.
From an employee perspective, a minority interest ESOP provides significant motivation and supports strong employee engagement. Though not controlling the business, their shareholder status gives them a voice—a knowledgeable voice at that—in operating the business. Their interests become more closely aligned with the majority owner’s interests and a powerful I Have a Stake in this Too! culture flourishes.
And, as a type of defined benefit plan, minority interest ESOPs allow employee-owners to build a nest egg for retirement without contributing their own money.
Last—and certainly not least—are the tax advantages. Why so good? It’s because the federal government believes strongly in employee ownership and uses the IRS code as an incentive to create ESOPs. The advantages are many, but here are some highlights:
- For owners of C corporations, Section 1042 of the IRS Code allows deferral of capital gains taxes on a sale of at least 30 percent of a company’s stock to an ESOP if the proceeds are reinvested in a “qualified replacement property” within 12 months. Certain other requirements on stock ownership also apply.
- Owners of S corporations are exempt from tax—usually federal and state—on the percentage of profits attributable to an ESOP. S corporations, however, do not qualify for all of the same benefits as C corporations.
Taking the ESOP Path
The practices for creating ESOPs are well-established.
Outside of setting up a trust—which is a separate legal entity—many aspects of an ESOP transaction are akin a third-party sale. The process involves independent legal representation for both parties—owners and the trust.
A normal due diligence process also occurs, and, in the case of a leveraged ESOP, financing sources are identified, usually through the sponsoring company.
One of the myths of ESOPs is that owners surrender the full value of their investment by selling to employees at a favorable price. Simply not true. ESOP rules require that businesses be sold at fair market value based on independent third-party valuation and issuance of a fairness opinion. Everyone pays—and gets paid—their fair share.
Whether he existed or not, Aesop’s wisdom lives on. If you’re a successful business owner seeking a clear path forward, investigating an ESOP could be similarly wise.
To learn more about ESOPs, we encourage you to attend our upcoming event in May 2022. We will be providing an overview of ESOPs and also hearing from two business-owners who sold all or a portion of their business to an ESOP. Register for the event HERE.
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