Tag Archive for 'Employee Stock Ownership Plan'

ESOPs as an Exit Strategy for Owners of Construction Companies

By Chris Hirschfeld, ASA, MBA, Director of Exit Planning, Somerset CPAs and Advisors

Running a profitable business is a daily challenge for most business owners. Finding an exit strategy is a challenge that every business owner will eventually face. It is especially true for many in the construction industry. If you want to sell to management, how often do they have the funds to buyout the owner? If you want to arrange bank financing for a transaction, what impact will this have on your bonding? If you want your children to remain in the business, how willing is a buyer to honor that request? If you consider selling to a competitor, what is the risk of sharing proprietary information with your competition? What if the deal doesn’t go through? How often do Private Equity firms even look at construction companies for their portfolio of acquisitions?

The list of issues above is exactly why more and more construction companies are turning to ESOPs as an exit strategy. What is an ESOP? It stands for Employee Stock Ownership Plan. It is a vehicle by which business owners can sell their stock to the employees through an ESOP Trust. The ESOP Trust buys the shares for the benefit of all employees. Not only does it provide an exit strategy for the current owners, but it also creates an ownership mentality among all the employees because all employees will have an economic interest in the success of the business. 

An ESOP is a qualified retirement plan. Therefore, it is governed by the same rules that apply to other retirement plans such as 401k or SEP or SIMPLE IRA’s. ESOP plan documents will specify eligibility, vesting, and retirement ages, just like other retirement plans. The accumulation of value inside an ESOP grows tax deferred, just like all other retirement plans. Employees only pay ordinary income tax when they withdraw their funds from their ESOP account just like any other retirement plan. When employees retire, or leave the company for any reason, however, they must sell their stock back to the ESOP. The stock never leaves the company. The terminated employee may roll their cash proceeds into their IRA or 401k if they wish to further defer taxes on their ESOP account after retirement. The one thing that makes an ESOP unique among retirement plans is that, by law, ESOPs are allowed to hold employer stock as its only security. 

When setting up an ESOP, current owners must sell their stock at fair market value, as derived by an independent appraiser. This is a market-based price which gives owners a value comparable to what the current market would bear. Often, “fair market value” is a higher price than formulas many companies have in place within their buy-sell agreements. Once the owners sell their shares to the ESOP, the ESOP Trust will allocate shares to employees over several years. This creates a long-term incentive for employees to remain with the company. It is why ESOPs have become such a wonderful retention tool. It is like a “golden handcuff” for all employees. If they leave, employees lose their unvested balance and also walk away from the potential of future share allocations. 

One of the biggest benefits to ESOP-owned companies is that management does not have to change. Corporate governance does not have to change. The day-to-day operations do not change. The company remains local. Headquarters will not be moved out of state. The local community benefits when companies don’t sell to out-of-state companies. There is one additional benefit to the owners who sell their shares to the ESOP. If they remain employees after selling their stock, they may also participate in the ESOP to build additional wealth.

In today’s tight labor markets, ESOPs are especially attractive. Imagine being in competition for new hires. Your company can offer not only salary, wages, and a 401k plan, but also a second retirement plan that the company contributes to (not the employee). How many employers offer two retirement plans? This will make your company more attractive to potential new hires in a tight labor market.

What types of companies make good ESOP candidates? ESOP candidate companies should be profitable, with stable earnings and some growth potential. If the company has the capacity to borrow money, the selling shareholders can get more cash up front as part of the deal. Owners who want to keep the company local will find ESOPs attractive. If you already have an employee-ownership culture, your employees will treasure the ESOP benefits.

ESOPs are only available to corporations. LLCs and Partnerships would have to convert to either an S-Corporation or C-Corporation before forming an ESOP. One of the advantages of a C-Corporation that forms an ESOP is that the sellers can get tax deferral on their capital gains if the ESOP buys 30 percent or more of the ownership. One of the advantages of an S-Corporation forming an ESOP is that income taxes on corporate profits can be eliminated. S-Corporations do not pay a corporate income tax. Corporate income passes through to the shareholders who pay the tax. If an S-Corporation is owned 100 percent by an ESOP, the corporate income tax liability passes through to the ESOP, which is a qualified retirement plan. Qualified retirement plans pay no income tax. Therefore, a 100 percent ESOP-owned S-Corporation is a tax-free entity. Imagine not having to make income tax distributions equal to 30 to 35 percent of the corporate income each year or in quarterly installments. That cash can be retained and used for other corporate purposes (pay down debt, bonuses, acquisitions, etc.).

The company will incur added expenses to an ESOP. ESOPs require a trustee, an independent business appraiser (who appraises the stock each year for the benefit statements), and legal counsel. Additionally, a record-keeper/third-party administrator must be retained to administer the plan, file necessary annual tax forms and produce the employee ESOP benefit statements. The corporate income tax savings alone, however, can more than offset the increased operating costs for an ESOP.

In summary, there are several reasons an ESOP might be an attractive exit strategy for business owners in the construction industry. It allows the owners to sell their stock at a market-based price. It provides a means by which the owners can sell the company, but the company remains local. The ESOP has a built-in mechanism for buying shares when employees leave the company, so there is always a market for minority interests. ESOPs help build an ownership mentality among employees. An ESOP provides a second retirement plan for all employees that builds value over an employee’s career. This additional retirement benefit will make your company unique and creates an attractive recruitment and retention tool. ESOP-owned S-corporations can eliminate corporate taxes altogether, creating a unique source of cash flow unavailable to most other corporations. If you have a business that you would like to turn into a legacy, an ESOP just might be that vehicle.