ESOPs - Are They Right for Your Business?
On today’s show, Ed connects with finance experts Andy and Mark to dig into all things ESOP. Many people want to offer stock options to their employees but don’t really understand the implications or process. Andy Manchir and Mark Flinchum of Indianapolis based CPA firm Katz, Sapper and Miller chat with Ed and answer some of the most common questions regarding the what and why of ESOPS and unveil when ESOP formation is a good option—and when it’s not.
[01:40] About Andy
[02:13] About Mark
[03:06] About Katz Sapper and Miller
[05:25] What is an ESOP?
[06:19] ESOP like management buy out
[06:43] Third Party Sale vs. ESOP
[07:29] Who is a good ESOP candidate
[09:56] What industries are good ESOP fits?
[10:43] What companies aren’t good ESOP fits
[12:29] Who’s going to run the place?
[15:28] Owner is not looking to drive highest value
[16:27] Tax incentives
[16:45] Maximum Value
[18:02] Tax benefits of an ESOP
[20:44] How ESOPs are structured
[23:05.] ESOP benefits for employees
[:23:33] Business Owner Exit – Loans equity and guarantees
[26:33] Selling an ESOP
[28:10] ESOP and management succession
[30:14] Financing, Capital and ESOPs
[31:49] Number of ESOPs
[34:12] ESOP process
[37:16] ESOP professional team
About Andy Manchir
Andy Manchir is the director of Katz, Sapper and Miller’s valuation and ESOP services group. Andy provides valuation and ESOP advisory services with an emphasis on employee stock option services. Andy graduated from Indiana University. He is a certified management accountant, a certified exit planning advisor and is a member of the National Center for Employee Ownership. He is also an accredited member of the American Society of Appraisers.
About Mark Flinchum
Mark is a partner at Katz, Sapper, and Miller. He started with the firm in 1987 upon graduating from Indiana University and has become a trusted business and tax advisor to many clients. His expertise includes strategic tax planning, business analysis and structuring, advocacy in high risk matters and consulting in high risk issues. Mark has been involved in assisting clients with growth opportunities, financing structure, and succession planning issues. He has significant experience in planning, structuring, and negotiating M&A transactions. Mark represents several ESOP-owned businesses and has structured a number of business sales to existing and newly formed ESOPs. He is a CPA and a member of the American Trucking Association and the Ohio Trucking Association. Mark serves as a vice president on the board of the Indiana chapter of the ESOP Association and is a board member and treasurer for the Miller Backers.
About Katz, Sapper, and Miller
As one of the top 60 CPA firms in the nation, Katz, Sapper & Miller has earned a reputation as a leader in the areas of accounting, tax, and consulting services and is consistently named one of the “Best of the Best” accounting firms in the nation by INSIDE Public Accounting magazine. The firm is headquartered in Indianapolis and operates with roughly 350 employees nationally in offices located in Indianapolis, New York, and Fort Wayne, IN. The firm also has a specialty office in its transportation space in Oklahoma City. Andy and Mark formed the ESOP services group in 2011. Andy works primarily on the valuation side while Mark works with the accounting and backside. Even though they had both been doing ESOP services long before then, the pair saw a unique opportunity to bring a more robust service to the community.
A long time fan of ESOPs, Andy started at Katz, Sapper, and Miller following his first career stint in valuation in the independent firm and banking world. He was excited because KSM is itself an employee owned public accounting and consulting firm. When KSM works with a business owners regarding ESOPs Andy says they are able to speak in terms not only of other client experiences but from their own perspective as well.
As an accounting firm, much of the work KSM does is with closely held, small and medium sized businesses. Mark says that these are the types of businesses looking for succession plans and typically want to sell either to a third party or to their own employees—which is where ESOP services come in.
Learn More From This Podcast
What is an ESOP?
ESOP stands for Employee Stock Ownership Plan. Basically, the ESOP owns stock in the sponsoring company. Employers can create a retirement plan as an employee benefit of their company. The employee benefit plan then buys the companies stock. This Employee Benefit Plan, or ESOP, can buy 100% of the stock, creating an entirely employee owned company. ESOPs are not required to be 100% employee owned, but it is possible and it comes with a number of tax benefits. Another way of looking at it is that an ESOP is like a management buy-out, but the process is more tax positive for the business. Overall, it’s a good alternative for business owners who want a good liquidity for their stock, but don’t necessarily want to sell to a third party
Remaining Part of the Community
An ESOP can be particularly appealing to owners whose companies play an important role within a community. Owners who are locally invested or provide a large number of jobs within a geographic location or industry sector might be particularly sensitive to the likely consequences of selling to a third party. In these sorts of cases, an ESOP can be a great way to avoid the potential fall out of a third party sale.
A Good ESOP Candidate
There are a few essentials for a good ESOP candidate.
Buy In—An owner must want to transfer ownership to their employees. The owner must be invested in the ESOP structure overall.
Debt Capacity—nothing is free and there is a cost to ESOP formation. Heavily leveraged companies are not good ESOP candidates
Capable Management Team—The future leaders of the company need to be well structured and the management needs to be strong without the owners direct involvement.
Headcount—ESOPs aren’t good for very small businesses and typically require an employee base of 20+ well paid employees. Because an ESOP is an employee benefit, the larger the company, the more tax savings that will accrue to you as an ESOP company.
Profitable—Companies with a history of losses or a seller looking for a quick exit strategy aren’t good candidates
What Industries are Good ESOP fits?
A lot of industries can work well as an ESOP. Professional services are a particularly good fit because those employees are skilled professionals and businesses must be competitive to woo the best talent. If a business can offer them stock as an incentive, it’s a way for professional service firms to differentiate themselves. In this way, ESOPs can be an employee attraction and retention tool. Construction, specialty trade and transportation have all been very successful with ESOP structures.
The medical practice sector, real estate and tech start ups aren’t typically a good fit. Issues with ownership, heavily leveraged and loss operating companies are all issues that aren’t benefitted by ESOP formation.
Managing Leadership in a New ESOP
Much of the time, existing leadership teams actually do have the capacity to successfully run their company, but ownership doesn’t see it. Because of how common it is for owners to feel like they are indispensable, Mark and Andy often recommend a third party evaluation to help prove just how capable teams really are. And they don’t stop there—if there is a hole in the leadership structure, they recommend strategic hiring. Whether it’s recruiting from the outside or internal training it’s crucial to have a good team in place.
An ESOP is not always the most profitable exit for an owner. Often, strategic third party buyers bring more immediate value. But Mark cautions owners to be wary of selling to the highest bidder. In one case, a third party buyer offered 25% higher bid for a company than the ESOP could afford. However the net outcome of the ESOP sale after tax proceeds came in at 10% above that highest bid.
Consider Maximum Value Above Buyer Offer
Andy encourages sellers to always look at the Maximum Value on an after tax basis. Consider whether the business will be required to sell assets or if it can net more from taxes. For instanceC-corps are allowed to sell the ESOP and defer their capital gains from that sale. (Tax section 1042)
ESOP tax benefits
If a person is a selling shareholder, ESOP can only buy stock which is taxed as capital gains to the extent that the sales price is higher than the tax basis. Most third party sales are a buyer looking to buy assets. The sale of assets have an ordinary recapture tax. The third party buyer wants to access the step up to the market value of those assets which means future depreciation will offset future taxable income. Under the tax reform act, those assets could be 100% tax deducted in the year of acquisition. Because ESOP can only buy stock, it’s a benefit to the seller, because he or she will pay less tax. As an ESOP, particularly a 100% S-Corp ESOP, income is tax exempt from federal tax. 100% flow through S-Corp ESOP pays no federal taxes. While they won’t incur state income taxes, they will have to pay other state taxes. Hungry for revenues, ESOPs still must pay things like franchise taxes, business taxes, commercial activity taxes etc.
How an ESOP is structured
ESOPs are a retirement plan and are held in a trust. This means that owners don’t need to even inform employees prior to forming an ESOP. Forming an employee stock ownership plan in trust requires hiring a trustee. The trustee looks out for the benefit of the employees and they carry a fiduciary duty to look out for the employees. The entire process is run through a third party so that everyone is properly protected.
Indebtedness and ESOP
Employees don’t provide any of their own personal guarantee to cover an owners buyout at their exit. While this means that employees aren’t personally on the hook it does limit the amount a business can borrow. ESOPs are a leveraged buy-out, which is why it works really well with businesses who don’t have too much debt already. In 2019, there is a healthy market for lending activity on ESOP formations. For business owners looking for quick exits such as a 100% buyout in year one, ESOP isn’t the best option. For business owners who have a few years left to transition, ESOPs can be a great option. Other business owners split up the process and sell the stock in chunks, which can be beneficial since their slow buy-out will reflect current market values.
ESOPs that have matured do have the opportunity to sell and while the process is a little bit different, they can be sold like any other company. It’s important to emphasize that ESOPs aren’t quick fixes for management or structural problems. Andy and Mark stress that leadership strategies should be spelled out during the formation process. Over time, Andy says that the ESOPs leadership will start to look more like the corporate governance model seen in publicly traded companies. Having a board of directors that include one or more independent directors have been quantifiably successful, in part because those companies are being run for maximum efficiency.
Financing, Capital and ESOP
Surprisingly loans like the SBA programs can be used for ESOPs. Typically though, ESOPs will require a conventional business loan and the company needs to be credit-worthy in order to qualify. The difference today is that banks are starting to recognize the tax benefits. ESOPs are still a niche and Andy points out that the number of ESOPs formed yearly are in the hundreds, not the thousands. This means that people considering ESOP formation need to seek out the right partners.
Consider an ESOP?
Owners interested in forming an ESOP should start with a feasibility study. KSM defines that as a valuation plus. Andy says that valuation alone can be a difficult obstacle to overcome largely because there are so many moving parts in any business. Understanding the companies ability for long term value and pay-back is a crucial part of the feasibility study. It’s also important to understand how stock options are going to impact employees. Understanding how the transition is going to affect each of the main stakeholders—the share-holder, the company and the employees is critical for long term success. Getting from feasibility to action requires the assembly of a professional team including ESOP counsel, a trustee, a valuation firm to value the stock for the transaction, corporate council and a third party administrator. There will likely be new policies and procedures following the formation of an ESOP.
Last Piece of Advice?
From Andy:” Pay attention to who’s on the bus. No matter what kind of company you have—whether it’s employee owned or not, investing in your team can bring long term value to your company.”
From Mark: “Increasing the value of your company looks largely the same whether you want to sell to a third party or form an ESOP.” Trimming unnecessary fat from the business
To learn more about ESOPs, KSM has a robust library of white papers to help people educate themselves. To download those papers and connect with Andy and Mark, visit www.ksmcpa.com/esop