A business owner faces several options when deciding how to transition their business to the next generation of ownership. When the owner wishes to sell the company (as opposed to gifting it to heirs), the choices are either to an outside third-party or to the company’s key employees. However, in many cases, there are no willing outside buyers and the only option is to sell the business to key employees.

Selling a business to key employees is often accomplished using either an Employee Stock Ownership Plan (ESOP) or a Management Buyout (MBO).

An ESOP is a defined-contribution retirement plan qualified under the Internal Revenue Code under section 401.

There are currently more than 7,000 ESOPs in the United States covering more than 13.5 million employees, according to the National Center for Employee Ownership. Most ESOPs exist in private companies — public companies account for fewer than three percent of all ESOPs.

Similarities and Differences

While ESOPs and MBOs are similar in structure and process, there are some key differences. With both methods, your company contributes ownership shares or cash into a tax-exempt trust, with the cash used to buy stock on behalf of employees. The cash contributions are tax-deductible for your business and tax-deferred for your employees — who don’t have to pay income tax on the money until they receive ownership shares later.

One of the biggest differences between an ESOP and an MBO is that only key managers participate in an MBO, not rank-and-file employees. Also, an outside management buyout firm is usually involved with an MBO, but not with an ESOP. Also, an ESOP can be structured as an all-cash sale or as an installment sale.

Another difference is the fact that ESOPs generally offer more flexibility than MBOs. With an ESOP, you can transfer ownership of the company to your employees over time if you choose, thus gradually phasing yourself out of the business. This way, you can maintain a controlling interest in the company while remaining actively involved in management and operations — even if you have sold a majority interest in the business to the ESOP.

An advantage of an ESOP is that it is permitted to take on debt, unlike any other retirement plan. In most situations the company’s key employees do not have the funds necessary, outside of the ESOP structure, to pay the owner a fair market price for the company. The Plan is permitted to take out a loan from a commercial lender, secured by the assets of the company with repayment from company cash flow. The loan is used to buy-out the owner, either in whole or in part depending on the size of the loan that a lender is willing to make. The original owner puts up the rest of the ownership (cash or stock) into the Plan, as a lender seeking repayment over time.

In an MBO, managers may also secure a loan to buyout the original owner, but lenders usually require the participating managers to secure a significant amount of private financing, usually in the form of their own cash-contributions.

ESOPs also offer greater tax advantages than MBOs. With an MBO, the principal portion of debt used to finance the buyout has to be repaid with after-tax dollars. Because an ESOP is a retirement plan qualified under Internal Revenue Code section 401, the principal portion of debt used to purchase shares can be repaid with tax-deductible dollars.

While ESOPs and MBOs can offer tax and other financial benefits to owners looking to sell their companies, perhaps their biggest benefit is the positive impact that such programs can have on employee productivity and morale.

Studies have indicated that employees who have an ownership stake in the companies they work for not only work harder than non-owner employees, but they also tend to be more loyal to the business. This often results in lower absenteeism and employee turnover. And all of this can increase the business’ profitability, valuation and ultimately, its selling price.

Start the Planning Process Early

To help ensure the success of an ESOP or MBO, you should start planning and preparing for the transaction as early as possible — ideally, up to two or three years before the process begins. As you prepare, think about such questions as:

  • On what approximate date would you like to start the process of transitioning ownership of your business to your employees and/or management team? And by when, ideally, would you like for this transition to be complete?
  • What are your main goals after the transition is complete, and how much money will you need to realize from the business sale to reach these goals? For example, your goals could include to retire or to start another business.
  • Are your employees and/or key managers prepared to assume leadership of the business after you are gone? You should begin the process of identifying and grooming future leadership long before the actual ESOP or MBO process itself commences.
  • Will your workers thrive as employee-owners? Not all employees have the kind of entrepreneurial mindset that is necessary to maximize the benefits of an ESOP or MBO.
  • When is the last time you had a business valuation conducted? You will probably need to have a new valuation performed as the date of the ESOP or MBO draws near.

Keep in mind that there are both upfront and ongoing expenses involved in an ESOP or MBO that can make these plans cost-prohibitive for some small businesses. Also, ESOPs and MBOs tend to take a long time to consummate, so they usually aren’t appropriate for owners who need to complete the sale of their business quickly.

Assemble Your Team of Advisors

It’s important to bring together a team of the right advisors to help you address the important questions and issues that arise as you organize the transfer of your business.

This team's overall objective should be to help you determine your goals and create the right plan to achieve them. Most advisory teams are comprised of a CPA, an attorney with business and estate planning experience, a financial planner, a banker, an insurance agent and a certified business appraiser. Key employees who will be ESOP participants should be included on the advisory team so that they have a sense of ownership in the Plan that they will be tasked with implementing. Working together, the advisory team can help you formulate a plan that successfully addresses the key issues of tax and retirement planning, business ownership, and management.

City National, as a matter of policy, does not give tax, accounting, regulatory or legal advice. The effectiveness of the strategies presented in this document will depend on the unique characteristics of your situation and on a number of complex factors. Rules in the areas of law, tax and accounting are subject to change and open to varying interpretations. The strategies presented in this document were not intended to be used, and cannot be used for the purpose of avoiding any tax penalties that may be imposed. The strategies were not written to support the promotion or marketing to another person any transaction or matter addressed. Before implementation, you should consult with your other advisors on the tax, accounting and legal implications of the proposed strategies based on your particular circumstances.

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