Uncle Sam's Going Away Present to Business Owners
Uncle Sam has provided a generous tax subsidy (that is not utilized nearly as often as it should be) to business owners who are exiting their businesses. It is a complex program that is not well understood and frequently used inappropriately.
About a year ago I wrote a high-level article on the subject, but I have since been asked to elaborate on this topic, which I will do with a case study involving a deal I am currently working on.
Recently I was hired to sell a company that had two principal shareholders: the founder, who owned 51 percent of the stock, and the CEO, who owned 40 percent of the stock. The 49-year-old founder, who was no longer actively involved in the business, wanted to cash in his controlling ownership position and go into the ministry full time.
The 58-year-old CEO, on the other hand, was not ready to hang up his spurs. However, the CEO, who had been displaced twice as a result of buyouts of the companies he had worked for, was terrified that if a private equity firm or a strategic buyer took control of the business he would lose his job the first quarter the company failed to meet its projections.
The founder’s primary goal in the deal was to stash away sufficient money to allow him to live the rest of his life off the income from his investments. The CEO’s hot button was job security for another five years before he was ready to cash out.
After many months of effort, we secured several fair offers from private equity groups to purchase the founder’s shares, but both the founder and CEO had reservations. If a controlling stake was sold to a private equity group, an unknown entity would control the fate of the CEO. And while the founder recognized that the offers were fair, the tax bite on the sale of his stock would barely leave him enough money to generate his required level of current income given today’s low interest rates.
I proposed a solution that addressed both their concerns, with a little icing on top for the rest of the employees, which made both the founder and the CEO happy.
Through a leveraged ESOP (employee stock ownership plan) the founder could defer his taxes on the proceeds of the sale and thus have 20 percent more invested to generate an income. And the CEO would not be working for an unknown private equity firm or corporate boss.
The controlling stake in the company would be voted by the trustees of the ESOP, which would include the founder and a couple of other employees. This made the CEO feel much more secure. A few added benefits made the decision a no-brainer:
The workers who had built the company would receive, at no cost to them, valuable stock which they never could have afforded to buy;
The pressure on the CEO to deliver future profits was eased because pre-tax earnings could be used to pay back much of the principal on the loan; and
When it comes time for the 58-year-old CEO to cash out his shares, he will have a ready buyer — the ESOP.
Sound too good to be true? It’s not. So, why aren’t these deals more common? Leveraged ESOPs are the Rodney Dangerfield of corporate finance. They get no respect.
Essentially an ESOP is a trust, set up for the benefit of the company’s employees, that can borrow money based on the assets and cash flow of the company. Technically, an ESOP is an employee benefit plan, so it is regulated by the U.S. Department of Labor. And with more than eight million workers owning shares in their employer through an ESOP, the ESOP lobby has strong political clout, as I quickly learned when I was running corporate finance policy for Bush senior.
ESOPs were established by Democrats as an incentive to promote employee ownership, but they are embraced by Republicans because they are equally beneficial to business owners. The primary attraction to the business owner is that if he or she sells at least 30 percent of the shares of the company to an ESOP, he or she can invest the proceeds in income-producing securities and indefinitely defer taxes due on the sale of their stock. Assuming a 15 percent federal capital gains tax, an 8.25 percent state income tax (this was a North Carolina company), and the sale of $10 million in stock, rather than having less than $8 million of after-tax proceeds earning interest, an owner would have $10 million generating income off which to live.
Another advantage is that of the money used to retire the debt, an amount equal to up to 25 percent of the annual payroll is tax deductible each year. If the company borrowed $10 million to buy the owners’ stock and the loan amortized in five equal annual installments, in addition to covering its interest payments, the company would have to earn about $3.2 million a year to cover the $2 million principal amortization (assuming a 40 percent effective corporate tax rate). With a properly structured ESOP, the company would only have to earn $2 million a year to repay the principal.
All told, using the leveraged ESOP could result in up to $6 million in saved corporate taxes plus $2 million in deferred personal taxes on a $10 million transaction. Where else can you fund such a subsidy?
As the loan is repaid, the shares acquired by the ESOP are allocated to the employees (who have been with the company the designated time period) on a pro rata basis according to their income. On most matters, the shares may still be voted by the trustee. When an employee leaves the company, the ESOP repurchases the shares from him or her based upon the current market value of the stock, so workers not only receive free stock, they get the profit from the appreciation in the stock, which serves as a tremendous incentive to the workforce. The ESOP can stretch out payment for repurchased shares over several years, which is a good idea if it is still paying back the ESOP debt.
A leveraged ESOP also works for an owner who wants to take some chips off the table but remain involved in running the business. He or she could sell part of their shares to an ESOP, invest the proceeds on a tax-deferred basis, serve as a trustee voting those shares and later sell the entire company (or just their remaining shares). Not only has the owner diversified his or her assets, they have created an opportunity for the employees to benefit from the ultimate sale and an incentive to work toward it. The one catch is that if the entire company is subsequently sold it needs to be at least three years after the ESOP was established to avoid an onerous excise tax.
One of the reasons more business owners do not travel this route is that the firms that promote ESOPs often lack the investment banking skills to finance the deal creatively. They simply go to a bank that will use the owner’s proceeds from the sale of their stock to serve as the collateral for the ESOP loan. In that case the owner really hasn’t completely sold the shares because the proceeds are not fully theirs until the loan is paid off. With some creative financing, as we used in this deal, this dilemma can be resolved.
Another reason leveraged ESOPs have a mixed reputation is that they are often installed in companies that lack the profile to succeed with significant leverage. A successful ESOP company should be a successful company. Companies with inconsistent cash flows, those already burdened with debt, or in a declining market generally encounter difficulty repaying the loans. Moreover, companies that lack competent management or are not prepared to run effectively without the services of departing shareholders are a recipe for disaster if sold to an ESOP.
In other cases, the owners’ shares are sold to the ESOP at above market prices, placing an undue burden on the company to repay the debt. Although the Department of Labor requires a professional business valuation stating the price is fair, most valuation firms are not in the M&A business and their theoretical analysis may be far removed from market realities.
Finally, ESOP companies often fail to take advantage of derivative securities such as interest rate caps or swaps to limit the potential risks of rising interest rates. So ESOPs get a bad wrap because of user error, not because they are a defective concept.
A leveraged ESOP is an incredible opportunity for the right company at the right time. They benefit owners and workers alike, all at the expense of Uncle Sam. But they need to be established with a great deal of consideration given to financial and strategic concerns, not just the legal and accounting requirements.
Michael Jacobs, Author
Michael Jacobs is the CEO of Jacobs Capital and Professor of the Practice of Finance at The University of North Carolina at Chapel Hill. He's the author of several books and a certified speaker.
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