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Employee Stock Ownership Plans Deserve a Close Look for Furniture Business Transition: Part Two - Rules and Financing

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In my last article on using an Employee Stock Ownership Plan for business transition, I briefly outlined the tax benefits of ESOPs as a business transition tool. ESOPs, you will recall, are a kind of employee benefit plan designed to invest in employer stock. The company sets up a trust for the benefit of employees, then makes tax-deductible contributions to the trust to enable it to buy shares. 

In this article, I look at how ESOPs can be financed and the rules you must comply with to have an ESOP.

Financing

The simplest way to use an ESOP to transfer ownership is to have the company make tax-deductible cash contributions to the ESOP trust, which the trust then uses to gradually purchase the owner's shares. For instance, Kentwood Office Furniture in Grand Rapids, a 122-employee office furniture reseller, started an ESOP in 2012 by contributing cash to the plan to make an initial purchase in the next year. Alternatively, the owner can have the ESOP borrow the funds needed to buy the shares. In this way, larger amounts of stock can be purchased all at once, up to 100% of the equity, although banks are usually reluctant to loan for a full buyout all at once. For instance, in 2010 Sleep Train, the fourth largest mattress retailer in the U.S., borrowed money to fund an ESOP to buy 25% of its stock. Sleep Train founder and CEO Dale Carlsen said at the time that “We’ve got a great team of individuals who deserve to be rewarded for their hard work and the ESOP plan we’ve developed is designed to do just that.”

Many ESOPs start this way, transferring part of the ownership in an initial transaction, then buying the remaining shares some years later. Sleep Train has done a number of acquisitions of smaller mattress retailers since the ESOP as well, effectively including them in the ESOP too. Sleep Train has seen significant increases in their ESOP value since its inception.

Like Sleep Train, many ESOPs start out buying a minority of the shares. In some cases, they continue that way long term; in most cases, this is a first step towards eventual 100% ownership. Others just continue as minority ESOP owned companies.

Perhaps half of all ESOPs, however, are funded instead by a seller note. The ESOP acquires the shares then pays back the seller at a reasonable rate of interest (not more than what a commercial lender would charge for loans of similar risk.) Sellers often like this idea because not only do they get their shares sold, but they get a reasonably good rate of return on the note.

How Much Will the ESOP Pay?

The price the ESOP will pay for the shares, as well as any other purchases by the plan, must be determined at least annually by an outside, independent appraiser. The appraiser's valuation will be based on several factors to determine what a willing financial buyer would pay. Discounted cash flow, expected future earnings, book value, the company's reputation, future market considerations, and other factors will be considered. Note that a strategic buyer, such as a competitor, might pay an additional premium because when the target company is acquired, there are perceived operational synergies that make the target more profitable to the buyer than it would be as a stand-alone entity. The ESOP cannot match this price because it cannot generate these synergies. Sales to synergistic buyers do trigger capital gains taxes, however, and often come with numerous contingencies.


How Gets How Much When and Other Key Rules

ESOPs are much like other tax-qualified retirement plans. At least all employees who have worked at least 1,000 hours in a plan year must be included. They receive allocations of shares in the ESOP based on relative pay or a more level formula. If there is an ESOP loan, the shares are allocated each year based on the percentage of the loan that is repaid that year. The allocations are subject to vesting for as long as six years. Employees do not receive a distribution of shares until they terminate, and then the distribution can be delayed for five years if for reasons other than death, retirement, or disability. The plan is governed by a trustee appointed by the board; employees only have very limited required voting rights (they do not have to elect the board, for instance), although companies may provide additional rights.

If you are willing to live with these rules, and an ESOP makes sense financially, then an ESOP may be the best way forward. Make sure, however, to get qualified, experienced advisors as ESOPs are a specialized area demanding specialized expertise. In the next installment, I will look at how to determine is an ESOP is right for you.

About Corey Rosen: Corey Rosen is the founder of the National Center for Employee Ownership, a nonprofit information, membership, and research organization. Details on ESOPs can be found at www.nceo.org.

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