Selling Your Business to an ESOP: Four Steps Every Owner Should Understand

Employee Stock Ownership Plans (ESOPs) are becoming an increasingly popular exit option for business owners in the US. As of 2023, there were 6,609 total ESOPs in the U.S. holding over $2 trillion in assets. However, many owners are unfamiliar with the steps involved in selling to an ESOP. These steps can be broken down into four sections: Testing the Fit, Assembling the Team and Designing the Deal, Negotiating and Closing, and Operating as an ESOP.

Step 1: Testing the Fit

The first step in transitioning ownership to an ESOP is a feasibility study, which involves receiving a preliminary business appraisal and analyzing the company’s cash flows to understand how much debt it can service. Often, the best candidates for ESOPs are established companies with strong margins, reliable cash flow, and good prospects for growth. ESOP transactions typically require large amounts of leverage, so banks will only be interested in lending if they are confident that the company will be solvent and able to service the debt. Some companies, such as early-stage start-ups or established firms in late cycle decline, may not be a good fit because there isn’t a reliable source of funds to service debt, or growth in value is not likely. If this is the case, it’s best to discover this early rather than in the due diligence stage.

Step 2: Assembling the Team and Designing the Deal

The seller will want to engage a legal advisor and a financial advisor. Meanwhile, the company will need to engage an ESOP trustee to act on the ESOP’s behalf. In ESOP transactions, it is common to sell a company in small portions over many years or all at once; it depends on the objectives of the seller. A strong finance and legal team can greatly improve the chances that the deal structure will satisfy an owner’s desires. Typically, the transaction price will be less than what a strategic buyer would be willing to pay. However, in exchange, the seller can ensure the company retains its legacy, potentially receive favorable tax treatment on the sale, and negotiate the terms of a seller note. Seller notes are frequently a part of ESOP transactions. This can be to the advantage of the seller because many retiring business owners would prefer to receive an above-market regular interest payment from the company that they built. The seller note will be subordinated to any bank loan. This requires the seller to carry credit risk which can be negotiated into a higher interest rate.

Step 3: Negotiating and Closing

Once initial expectations for the price and deal structure have been developed, the ESOP’s trustee will hire an independent business appraiser and legal counsel. Even if the seller and employees are on amiable terms, the seller should expect negotiations with the trustee to be similar to an arm’s-length deal. The trustee is a fiduciary under ERISA and is legally required to act solely in the interest of the ESOP plan participants. ERISA also requires that the plan does not purchase the company at a price above the fair market value as determined by an independent appraisal.

Step 4: Operating as an ESOP

Once the transaction has been completed, ESOPs have several unique requirements that differentiate them from a typical company. A seller should be aware of these requirements to prepare the company for the compliance procedures. These include annual independent business valuations, possible ESOP plan audits, Form 5500 filings, and repurchase obligation management. During the negotiation process, the seller and trustee may have developed a transition plan that includes the period that the owner will remain in place either as a consultant, part-time employee, or full-time employee working for the ESOP. Depending on the industry, the seller may be expected to remain for multiple years to ensure a smooth transition.

Conclusion

ESOPs can be an excellent exit option for business owners who want to provide their employees with ownership and allow the company to retain its legacy. The process of selling the company to an ESOP can be confusing for those unfamiliar with the legal and financial idiosyncrasies associated with the process. For these reasons, it is critical to involve experienced legal and finance/accounting teams from the very beginning steps.

At McKonly & Asbury, we have extensive experience with ESOP feasibility, valuation, and annual compliance procedures. If you have any questions regarding ESOPs, please contact T. Eric Blocher CPA, ASA, CVA.

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