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According to data from the Census Bureau’s 2016 Survey of Entrepreneurs (the latest available survey), there were 5.6 million employer firms in the United States, and 99.7% of those businesses employed
500 people or fewer. Guidant Financial and LendingClub’s Report on the State of Small Business reported that 57% of small business owners are age 50 or older.
Develop a Plan
As owners of these businesses begin to think about retiring, they need to develop a succession plan. Although many will look to sell their businesses outright, an employee stock ownership plan (ESOP) offers another solution. ESOPs are qualified retirement benefit plans (similar to 401(k) plans) that give employees an ownership interest in the company. Data from the National Center for Employee Ownership (NCEO) shows that nearly 6,700 of these plans exist nationwide. Of those companies, the greatest numbers (22%) are in manufacturing and 11% are in construction, which may be surprising.
Establish an ESOP
The number of companies with ESOPs may seem low, but part of the reason may be that companies simply are not familiar with ESOPs or how they work. Essentially, ESOPs are employee benefit plans that are funded by tax-deductible contributions by the employer in the form of either company stock or cash. That contribution is used to purchase company stock.
ESOPs operate through a trust or other named fiduciary, which means that the administrative costs can be high. Other associated costs can be high as well. For example, the process of setting up an ESOP usually starts with a feasibility study conducted by an outside consultant. This study will include a business valuation, an analysis of the company’s cash flow and debt capability and a suggested structure for the ESOP.
If it is determined that an ESOP is a good option and the owners agree with the terms and suggested structure, a trustee needs to be identified. The trustee will hire a valuation firm to oversee the terms and issue a fairness opinion. This opinion will focus on the financials of the deal. Once everything is agreed to, both the company and the trustee will need legal counsel. The associated expenses may be high, but the tax savings for ESOPs can be substantial. For example, a business owner who sells more than 30% of his or her company to an ESOP may be able to defer any capital gains tax by rolling over the proceeds to a qualified investment. No tax would be due until those investments are sold.
ESOPs also have an intangible benefit: company morale. Because the company’s employees also are part owners in the company, they have a vested interest in seeing the company succeed. Ownership-based cultures tend to boost employee satisfaction and retention. Not all companies should consider ESOPs as a succession strategy. They work best for companies with
- annual payroll of at least $1 million,
- at least 20 employees,
- solid management team,
- strong cash flow, and
- debt capacity.
ESOPs can be an excellent option for business succession, but you have to know a lot more about them before you can decide whether they are a good fit for your company. Call us today for help devising a strategic succession plan for your business.