More thoughts on ESOP Trusts

I’ve been having a very interesting email exchange with Corey Rosen from the National Center for Employee Ownership. This is the trade association that supports ESOP’s in the country. They are a wonderful resource for anyone considering an ESOP and I suggest strongly that before doing an ESOP transaction that you contact this group to get their take on ESOP’s and what they can do for you or your Client’s company.

When we help Clients look at an ESOP opportunity, we must look at the after tax result of what an ESOP transaction does. Also, we should run both a tax free exchange scenario versus one where the selling owner pays taxes and participates in the ESOP. In some cases, having the owner get a second bite of the apple through ESOP participation might be more favorable than selling their company and paying no capital gains taxes.

I do believe that the selling owner needs to spend about five to seven years with a continuing interest in the company for an ESOP to be successful. (I’m speaking of companies that have annual sales of $5MM to $40MM) The selling owner will most likely want to keep an active interest because of the risk of company default on notes to either the selling owner or the bank.

Keeping in mind that it’s natural for the owner to remain interested, it also makes sense during the feasibility stage to analyze whether immediately doing the ESOP as Sub Chapter S Corporation making the company tax free or through a re-organization using preferred stock with a tax free exchange for the selling owner is better. By better, I mean which gives the owner a better return for their business.

The other issue that needs addressing and can save all a lot of time is whether the fair market valuation an ESOP will receive is close to the real market value of the company. We have spent a significant amount of time with owners helping them understand the ESOP opportunity only to find out that the fair market valuation is between 20% and 50% less than the after tax market value of the company. In many cases this is just too much money for the selling owner to leave on the table.

For this reason, I think it makes sense for us to spend some time and Client resources finding out the market value and fair market value of the company before starting the ESOP conversation. I think the selling owner needs to understand the economic impact right after they learn some basics about ESOP companies.

Corey was telling me that the NCEO thinks there are about 150,000 companies that could economically qualify as an ESOP company. I would probably put that number at around 300,000 which corresponds with the number of private businesses that are in the middle market. (Sales between $5MM and $1BB) Of that group probably 20 to 30% would opt out because the economic penalties in fair market value are too steep.

This means there are about 150,000 to 200,000 businesses that could and should consider an ESOP transaction. In most cases the owner will opt out of an ESOP for other exit or transition strategies. However, the ESOP conversation is a good one in that helps the transitioning owner look at their business in a holistic manner.

Thanks, Corey, for providing me food for thought. Your organization is fortunate to have you lead it.

Josh Patrick