The Buyer You Might Be Overlooking

Considering the Role of an ESOP in Your Family Business

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One obstacle many families face when it comes to selling the family business is the potential loss of identity, culture, and jobs that such transactions often leave in their wake.  Even if it is the right time for the family to sell, there may be a reluctance to do so for fear that a sale will trigger adverse developments for the company’s employees and communities.

  • If the family business is sold to a competitor, the buyer may elect to discontinue the company’s brand, eliminate “redundant” corporate overhead positions, or close operating facilities in a quest to achieve the cost savings that will help drive returns.
  • Private equity buyers may not take such aggressive actions in the short-run but will look to “flip” the business to another buyer within five years or so. This “exit-driven” mentality is foreign to the sustainability focus of many family businesses and can undermine the family culture that made the business successful in the first place.

A recent article by Paul Sullivan in the New York Times highlighted an option available to family shareholders: selling the family business to the employees.  Doing so has the potential to avoid the negative outcomes typically associated with corporate sales.

As noted in the article, there are approximately 6,500 employee-owned businesses in the United States and some observers believe that number could increase in the coming years if capital gains tax rates rise under the Biden administration.

Why would a family consider selling all or a portion of their family business to employees?  The article identifies three potential benefits.

  • Benefit #1 – Selling to Employees Allows the Family Business to Remain Intact. When the family business is sold to employees, the existing management team will remain in place and the family culture will likely persist in the family business.  This is often a critical concern for family shareholders who are wary that a buyer will disregard, or potentially destroy, the legacy of the family among long-time employees and within the communities in which the family business operates.
  • Benefit #2 – Tax Benefits for the Seller and the Company. Sellers in ESOP (employee stock ownership plan) transactions may be eligible to defer capital gains, and potentially avoid taxes that would otherwise be due.  Like all tax matters, it’s not always that straightforward, and the specific eligibility rules are beyond the scope of this post.  However, we note that many sellers do qualify for these benefits, which can materially enhance the overall economic benefit to the seller from the transaction.

Following the transaction, there are tax benefits for the company as well since contributions made (and dividends paid) by the company to the ESOP are tax-deductible.  The resulting tax savings increases the company’s cash flow available for reinvestment and growth opportunities.

  • Benefit #3 – Retirement Benefits for Employees. If the company performs well following the transaction, the contributions and dividends from the company, when coupled with growth in the value of the company’s shares, can provide retirement benefits for employees that exceed what would otherwise be available from traditional 401k or profit sharing programs.

Of course, every silver lining has a cloud.  There are two primary drawbacks to ESOP transactions for family shareholders.

  • Drawback #1 – Fair Market Value. Whether selling to a competitor or a private equity fund, such buyers may be willing and able to pay a premium price because of the cost savings or revenue synergies that they expect to achieve by implementing the types of corporate changes described at the beginning of this post.

Because an ESOP doesn’t anticipate making such changes, the nominal transaction price when selling to employees – known as fair market value – may be less than a strategic or private equity buyer is willing to pay.  Depending on the circumstances, the tax benefits described above may offset this potential drawback.

  • Drawback #2 – Regulatory Burden. Because ESOPs are qualified benefit plans, they fall under the purview of the Department of Labor.  So in any transaction with an ESOP, the DOL is a not-so-silent third party tasked with ensuring that the ESOP protects the interests of the employee participants.  Depending on the complexity of the ESOP, selling stock to employees may require a small raft of attorneys, accountants, trustees, and other advisors to ensure that the transaction and subsequent administration of the ESOP do not run afoul of DOL regulations.

If your family is considering a sale of the family business, don’t overlook your employees as a potential buyer.  ESOP transactions are not right for every family but can generate benefits for a broad range of stakeholders.

To discuss the fair market value of your family business and whether an ESOP transaction might be a good fit for your family, give one of our family business professionals a call.