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Employee Stock Ownership Plans Deserve a Close Look for Furniture Business Transition: Part Three

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by Corey Rosen, Founder, National Center for Employee Ownership

In my last articles on using an Employee Stock Ownership Plan for business transition, I briefly outlined the tax benefits of ESOPs as a business transition tool, the rules for the plans, and how to finance them. 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, the makes tax-deductible contributions to the trust to enable it to buy shares.

In this article, I look at how to determine is an ESOP makes sense and what your first steps should be if you decide to pursue the idea.

As appealing as ESOPs can be from a standpoint of legacy, taxes, and flexibility, they are not right for every company. Several factors must, at a minimum, be present:

  1. The company is making enough money to buy out an owner. The company must be generating enough cash to buy the shares, conduct its normal business, and make necessary reinvestments.
  2. If the company is borrowing to buy the shares, its existing debt must not prevent it from taking out an adequate loan. 
  3. If the seller wants to take the tax-deferred rollover, the company must be a regular C corporation or convert from S to C status. S corporations can establish ESOPs, but their owners cannot take advantage of the tax-deferred rollover described above.
  4. The seller(s) must be willing to sell their shares at fair market value, even if the ESOP pays less than an outside buyer would. An ESOP will pay the appraised fair market value based on what a willing financial buyer would pay based on a variety of factors. Sometimes an outside buyer can pay more for a company if it has a particular fit that creates synergies that go beyond what the company is worth on its own. If that price nets the seller more than what would be achieved on an after-tax basis selling to an ESOP (remember, the seller can defer gains on the ESOP sale but not a sale to a third party), then an ESOP only makes sense if the non-financial benefits of the selling this way outweigh the financial difference.
  5. Management continuity must be provided. Banks, suppliers, and customers will all want to be persuaded that the company can continue to operate successfully. It is essential that people be trained to take the place of departing owners to assure a smooth transition.
  6. The rules for an ESOP must be acceptable: ESOPs are required to be inclusive. If you want to limit ownership to just a few people, ESOPs won’t work, although you can provide ownership for key people outside an ESOP.
  7. You must be willing to deal with costs and complexity: ESOPs do require more management time to make sure you understand how they work. The costs of setting up a plan will typically run from $70,000 to $100,000 for “plain vanilla” plans and higher for more complex ones or lager companies. That is substantial, although the costs (including brokerage fees) for selling a third party are higher. These costs, however, typically make ESOPs prohibitive for companies with roughly 15 or fewer employees.

If you do decide to pursue an ESOP, make sure you get qualified advice. The National Center for Employee Ownership maintains a referral service of people experienced in this field.

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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