Selling In: Liquidity & Succession Using an ESOP
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The trust was formed under an Employee Stock Ownership Plan, or ESOP. The ESOP purchased stock from the other three shareholders for fair value using borrowed money. Santel, Wolfe and DeFrange did not pay any immediate taxes on their sale of stock to the ESOP. Alliance Material Handling will fund the ESOP using tax-deductible dollars to repay the borrowed money, and Alliance employees will gain owner- ship free and clear under the ESOP as the loan is repaid. Business owners, including MHEDA distributors like Alliance, Modern Group (Bristol, PA) and others, are increasingly turning to ESOPs as a corporate finance tool to provide for liquidity and succession. For the busi- ness owner, an ESOP is a way to cre- ate liquidity, preserve company inde- pendence, protect wealth, diversify assets, plan for an orderly and phased succession, and defer taxes. For em- ployees, an ESOP is a company-fund- ed retirement plan that offers an own- ership stake in the company. For the company, an ESOP is a way to fi- nance ownership transition in a tax- favored transaction. But what exactly is it? WHAT AN ESOP IS ESOPs are tax-qualified retirement plans created as part of the Employee Retirement Security Income Security Act (ERISA) in 1974. The ESOP con- cept dates back as early as the 1950s, when investment banker Louis Kelso first conceived that businesses nation- wide would be stronger and more profitable if employees of a company were offered a stake in the company’s success. According to the nonprofit National Center for Employee Owner- ship (www.nceo.org), today there are more than 11,000 ESOP companies nationwide covering more than 8.5 million employees. ESOPs are similar to other retire- ment plans, such as 401(k) and prof- it-sharing plans, but they have sev- eral distinguishing characteristics. Unlike other plans, which are re- quired by law to diversify their assets, ESOPs are required to invest primarily in the stock of the employ- er company. Also, unlike other retire- ment plans that generally invest employer contributions when re- ceived, ESOPs can borrow money to fund the purchase of a block of employer stock and repay this debt with future contributions. Therefore, ESOPs can be used by business owners to create an internal market to sell a block of company stock. The ESOP can purchase all or a portion of a company’s stock in one or more transactions, depending on the goals of the shareholders. For business owners who want liquidity and diversification in stages, an ESOP may be an ideal approach. The government provides special tax incentives to spur creation of ESOPs. For example, companies can fund the purchase of stock from shareholders using tax-deductible dollars. Shareholders generally can defer capital gains taxes on the sale of shares to an ESOP if the ESOP owns more than 30 percent of out- standing company shares, the compa- ny is or becomes a “C” corporation, and the selling shareholder uses the proceeds of the transaction to pur- chase stocks or bonds of any domes- Spring 2006 MHEDA 81 MONEY MATTERS M O N E Y M A T T E R S Liquidity and succession using an ESOP M HEDA company Alliance Material Handling Inc. (Jes- sup, MD) was formed by the merger of three partners in 2001. In 2004, Hobb Santel, Ted Wolff and Joe DeFrange were joined by a fourth shareholder: an ESOP trust created for the benefit of the company’s employees. SELLING IN by James G. Steiker Structured properly, ESOPs provide business owners with both liquidity and succession at a controlled pace while simultaneously creating an employee benefit based largely on the suc- cess of the business.
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Transcript of Selling In: Liquidity & Succession Using an ESOP
The trust was formed under anEmployee Stock Ownership Plan, orESOP. The ESOP purchased stockfrom the other three shareholders forfair value using borrowed money.Santel, Wolfe and DeFrange did notpay any immediate taxes on theirsale of stock to the ESOP. AllianceMaterial Handling will fund theESOP using tax-deductible dollars torepay the borrowed money, andAlliance employees will gain owner-ship free and clear under the ESOPas the loan is repaid.
Business owners, including MHEDAdistributors like Alliance, ModernGroup (Bristol, PA) and others, areincreasingly turning to ESOPs as acorporate finance tool to provide forliquidity and succession. For the busi-ness owner, an ESOP is a way to cre-ate liquidity, preserve company inde-pendence, protect wealth, diversifyassets, plan for an orderly and phasedsuccession, and defer taxes. For em-ployees, an ESOP is a company-fund-ed retirement plan that offers an own-ership stake in the company. For thecompany, an ESOP is a way to fi-nance ownership transition in a tax-favored transaction. But what exactlyis it?
WHAT AN ESOP ISESOPs are tax-qualified retirement
plans created as part of the Employee
Retirement Security Income SecurityAct (ERISA) in 1974. The ESOP con-cept dates back as early as the 1950s,when investment banker Louis Kelsofirst conceived that businesses nation-wide would be stronger and moreprofitable if employees of a companywere offered a stake in the company’ssuccess. According to the nonprofitNational Center for Employee Owner-ship (www.nceo.org), today there aremore than 11,000 ESOP companiesnationwide covering more than 8.5million employees.
ESOPs are similar to other retire-ment plans, such as 401(k) and prof-it-sharing plans, but they have sev-eral distinguishing characteristics.
Unlike other plans, which are re-quired by law to diversify theirassets, ESOPs are required to investprimarily in the stock of the employ-er company. Also, unlike other retire-ment plans that generally invest
employer contributions when re-ceived, ESOPs can borrow money tofund the purchase of a block ofemployer stock and repay this debtwith future contributions.
Therefore, ESOPs can be used bybusiness owners to create an internalmarket to sell a block of companystock. The ESOP can purchase all ora portion of a company’s stock in oneor more transactions, depending onthe goals of the shareholders. Forbusiness owners who want liquidityand diversification in stages, an ESOPmay be an ideal approach.
The government provides specialtax incentives to spur creation ofESOPs. For example, companies canfund the purchase of stock fromshareholders using tax-deductibledollars. Shareholders generally candefer capital gains taxes on the saleof shares to an ESOP if the ESOP
owns more than 30 percent of out-standing company shares, the compa-ny is or becomes a “C” corporation,and the selling shareholder uses theproceeds of the transaction to pur-chase stocks or bonds of any domes-
Spring 2006 MHEDA 81
MONEYMATTERS
M O N E Y M A T T E R S
Liquidity and succession using an ESOP
MHEDA company Alliance Material Handling Inc. (Jes-sup, MD) was formed by the merger of three partnersin 2001. In 2004, Hobb Santel, Ted Wolff and Joe
DeFrange were joined by a fourth shareholder: an ESOP trustcreated for the benefit of the company’s employees.
SELLING INby James G. Steiker
Structured properly, ESOPs provide businessowners with both liquidity and succession at acontrolled pace while simultaneously creatingan employee benefit based largely on the suc-cess of the business.
tic operating corporation.Unlike other “S” corporation share-
holders, if an ESOP is a shareholderof a company that is or becomes an
“S” corporation, the ESOP does notpay taxes on its share of the corporateincome. A company such as ModernGroup, which sponsors an ESOP thatowns 100 percent of company stock,is effectively tax-free because, as an“S” corporation, the company pays nocorporate income tax and the ESOP,as a tax-exempt shareholder, pays noindividual income tax on the corpora-tion’s income.
HOW AN ESOP WORKSThe first step in establishing an
ESOP is to analyze your company’sfinancial information, revisit yourbusiness plan, and determine whatyou want to accomplish with theESOP. The goal of this feasibilityanalysis, accomplished with or with-out outside professional help, is anapproximate valuation of the compa-ny and an ESOP transaction designthat will meet your goals.
A typical leveraged ESOP transac-tion works like this:1. The company establishes an
Employee Stock Ownership Trust.2. The Company borrows money
from a bank, usually secured by asecurity interest in the company’sassets.
3. The Trust borrows this moneyfrom the company, secured by apledge of the stock that it purchas-es with the money.
4. The Trust uses the borrowedmoney to purchase all or a portionof the company stock from thestockholder.
5. The bank may require the share-holder to pledge some of themoney it receives as security forthe bank’s loan to the company.
ESOP transactions are not “nameyour own price.” An ESOP must have
an independent appraiser determinethe fair market value of the shares ofcompany stock to be purchased bythe ESOP and cannot pay more thanfair value for the shares.
Structured properly, ESOPs providebusiness owners with both liquidityand succession at a controlled pace,while simultaneously creating an em-ployee benefit based largely on the
success of the business. ESOP compa-nies generally outperform their non-ESOP counterparts, measured by pro-ductivity and profitability. Participa-tion in an ESOP gives employees a“piece of the action.”
ESOPs can provide significant taxand organizational benefits for closelyheld companies. ESOPs work particu-larly well for established and profitablecompanies with good potential succes-sor management. The key downsidesof ESOPs are the need to borrowmoney for funding the transaction andthe relative complexity of ESOP trans-actions. Be sure to consult with anexperienced professional when con-templating an ESOP so you are awareof what will be involved with an ini-tial transaction and beyond. There mayalso be ways to use an ESOP transac-tion to accomplish important companyand shareholder goals that are notimmediately obvious.
If you are looking for an exit strat-egy that offers fair value for your
company ownership, doesn’t requirean immediate sale to a third party,and rewards the people who havehelped build your business, consideran ESOP. It may be the right “win-win” strategy for the company, theshareholders and the employees. Justask the shareholders and employee-owners of Alliance!
82 MHEDA Spring 2006
M O N E Y M A T T E R S
James G. Steiker is president of SES Advisors Inc.,
located in Philadelphia, Pennsylvania, and on the
Web at www.sesadvisors.com.
CONVENTION PRESENTER“Employee Stock Ownership Plans”
The government provides special tax incentivesto spur creation of ESOPs.
If You Want Employees to Think and Act Like Owners, MakeThem Owners. For more information about Employee Stock Ownership Plans,check out these Web sites:The ESOP Association www.esopassociation.orgThe National Center for Employee Ownership www.nceo.org
Should You Have An Employee Ownership Plan? Corey Rosenhelps you answer that question in his article from Winter 2001.More ESOP-related tips from MHEDA members Modern Group andCisco-Eagle appeared in Fall 2004. Read them again in TheMHEDA Journal Online.
