Driving Towards the Exit - Why ESOPs are a Great Exit Option

For a solid decade now, if not more, there has been a megaphone yelling that the "Silver Tsunami" was coming as all of the Baby Boomer business owners ran right out the door the minute they turned 65.  It was assumed that there would be lots and lots of businesses up for sale.

Well  it didn't happen as everyone thought.  Coming out of the Great Recession, Boomer owners needed to reestablish the profitability and value of their companies.  Then, as the economy resurged, it was fun to own and lead a business.  Business was great and the money made was attractive.

Another dynamic was at play.  If "50 was the new 30," 65 was more like the "new 45."  Owners still had gas in the tank because driving the car was still good fun.  

2020 humbled us all.  Whether the business was struggling to stay alive or keep up with demand, driving the car became more like the drive straight from Wisconsin to Colorado in one sitting after the good road food has long gone.  Today's Boomers are that much older and, having experienced the life-altering events of the Pandemic, are reprioritizing what is important in life.  The waves of a Silver Tsunami are building.  

And the question of "what are my exit options?" looms up ahead.

The standard options usually entail exploring whether there are:

• Members of the family interested in taking it over (usually not)
• Members of management interested in buying it (usually, but like the kids, undercapitalized)
• Potential strategic or financial buyers that would find the business attractive (assuming the business has transferable value)

A fourth option exists as well - employee ownership.  Whether through an Employee Ownership Stock Plan (ESOP) or other structures for employee ownership, this model holds many advantages for the right company, including:

• Significant corporate tax advantages which, depending on the entity's tax structure, may free up cash resources immediately or within five years for servicing the ESOP debt incurred to buy out the seller(s).  Once the debt from the buy-out is fully paid, these tax savings allow the company a strategic advantage over its competitors
• Ability to maintain continuity in the operation of the company, mitigating the threat of buyers coming in and making drastic changes or moving the company from its community
• Recognition of the prior and ongoing contribution of employees in the success of the company
• A potential to harness employee energy and commitment to drive strong growth in the value of the company by virtue of their ownership and vested interest in the company's performance

Employee ownership, and ESOPs in particular, are often disregarded as being too complex or too expensive to allow it to be considered as a viable option.  It's true that there are more complexities in structure and compliance, but they are not insurmountable. 

Then there are the costs of setting up an ESOP and maintaining it.   Here is where it's appropriate to compare the costs incurred to pursue the other options as well as an ESOP:

Third party sales often include obtaining a business valuation as well as hiring a broker/investment banker to take the company to market.  The typical range of fees for a broker/investment banker will be between 3% to 5% of the sale price.   For a company selling for $5 million dollars, that's approximately $150k - $250k in fees.  And you haven't paid for attorneys or accountants yet.

The cost of establishing an ESOP may range between $150k to $400k dollars.  Rather than a percentage of the sale price, most of the costs in an ESOP transaction are project or time-based, including the legal, accounting, ESOP advisor and trustee fees.  Once a company exceeds a certain threshold in value,  such as between $8M and $13.5M in this example, the costs of setting up of the ESOP may actually incur less in fees than the owner would pay in a third-party sale.

In addition, there are the costs of maintaining the ESOP as it is an employee benefit plan subject to ERISA.  These costs vary, depending on the number of plan participants.  While these expenses will hit the bottom line and, therefore, the annual value per share, the tax savings lessens their impact on cash flow.  At the same time, the seller knows that their company is now owned by people who care deeply about its success and its impact on employees' families and the community.

That said, ESOPs are not right for every company.  According to the National Center for Employee Ownership, generally speaking an ESOP works well if there are:

• At least 15 or more employees
• The company has a strong balance sheet where it can take on debt without crippling the cash flow needed for operations and withstanding economic cycles
• A strong management team in place that can grow and develop with the company once the owner steps fully out of the business

If the profile above matches your company, I would certainly recommend exploring an ESOP as a potential exit option.  Through experience as a board member for ESOP companies, I have seen firsthand the benefits unfold after the sale as the transaction itself causes little disruption or employee churn (relative to outside buyers), the management team steps up to their new ownership, and employees overall become more engaged in the company's success.

As more owners look to sell their companies, the competition for buyers will heat up.  Deal flow, as we sit here in mid-2024, is muted by interest rate and domestic and geopolitical concerns.  The best exit strategy is one that considers all the options, weighing out each one's pros and cons and how it best meets the owner's goals.  Further, there are opportunities to craft hybrid solutions, such as blending next generation ownership with ESOP ownership or outside ownership. 

The road to exit has many a winding curves.  Stay alert.  Look both ways and your route options.  Make the journey your own.