What does ESOP actually mean?
ESOP stands for Employee Stock Ownership Plan.
This week we talk about a great tax-saving method of exiting a business that can also take care of your employees for years afterwards. Sound too good to be true?
Andre Schnabl spoke to us about ESOP: a method of selling a business that could save millions in tax, as well as safeguarding the future of the firm. His explanation was fantastically simple so we recommend you take a listen, but if you only have time for the brief highlights of what we talked about, then read on:
How do the employees fit into it?
The principle is similar to how an employee contributes a percentage of their monthly paycheck to into a 401K retirement plan. However, the difference is that the ultimate value (and holdings) of their retirement plan is invested into their own employer, rather than whatever stocks, bonds or mutual funds a normal 401K has invested its money in to.
Now each employee literally has an invested interest in seeing the value and growth of the company grow!
Why would a company owner want to sell a business in this way?
There are a multitude of reasons, but to skim the surface, here are some key benefits:
- The owner can receive a market-rate price for their business without actually having to go out to the market.
- The owner can save or ELIMINATE on capital gains tax
- Selling a company to its own employees is a great way of safeguarding the future of the workforce after the owner retires.
- The general flexibility of this kind of deal is useful to help manage the different needs of the many people involved in the sale of a business.
How does the owner get their money in an ESOP?
Normally they would receive a proportion of the value of the business in cash up front (most of the time via bank financing), and then the rest of it through a note that would be paid out through the company profits in a certain time period and dependent on KPIs (Key Performance Indicators) agreed upon at the time of sale.
Where does the up-front cash come from?
There are many ways but the most common is leveraged bank finance (aka bank loan).
Why would the banks lend money to make this happen?
Because a trust would be set up to effectively ‘buy’ the company, and the banks would loan the trust a certain amount of money in order to do so. ESOPs have one of the lowest default rates among borrowers – better chance that the bank gets THEIR MONEY BACK!
Isn’t this risky for the banks?
Banks actually like these deals. For one, even though the trust itself doesn’t have any assets, the trust’s loan can be secured against existing company assets. Secondly, because ESOPs end up in the hands of employees, this makes banks confident that the future of the firm is sustainable. They figure that if the employees have a stake in it, they’re more likely to drive the business forwards.
How can this save on tax?
- If the deal is structured correctly, based on section 1042 of the tax code, the business owner can ELIMINATE Capital Gains! Depending on which state you live it this can be up to a 30.9% percent tax savings!
- 20% Federal tax rate savings
- 3.8% savings on the affordable health care act
- 7.1% Minnesota tax
- See your state combined capital gains tax HERE
- Debt that is accumulated by an ESOP is paid for PRE-TAX! This means the bank loan, sellers note, and other forms of debt can be paid back much quicker while significantly increasing company cash flow.
- This can be a 40% savings in tax!
Why is this good security for the employees?
Beyond the money they may make from their own salaries, there is a greater job security here than if the company was sold on the open market because now the employee is a part owner of their own company. An ESOP provides an incentive for the existing company to succeed because the employees can see the value of their shares rise along with the success of the company.
However, a third party buyer from the open market may have a completely opposite agenda, i.e. job cuts, restructuring etc. Also an ESOP can include certain incentives for the future management of the company after the owner has departed which creates the perfect scenario of management and employees pulling together to achieve the same incentivized goal.
How long does the ESOP sale process take?
The most difficult part of the process is determining whether an ESOP is actually the best option for the owner. After all the pros and cons are weighed and all parties agree, it would normally take in between three and four months to complete the formalities.
How can I contact Andre?