Is an ESOP Your Best Exit Strategy?

Originally published: 07.01.11 by Ruth King

It might be for profitable companies with high cash flow and skilled, engaged employees.

Many years ago, I worked with a 46-year old owner of an HVACR company. He suddenly died of a heart attack. His widow didn’t want to run the business. She sold off the telephone number, customer list, and other assets in a “fire sale” and closed the doors.

I’ve seen owners work in their companies for years and never bother to build assets (i.e., a maintenance-agreement base). When they could no longer work, they tried to sell the company. I saw the shock and disappointment when they discovered that their company had little value to prospective buyers, even if they could find someone who was potentially interested. The saddest part was that they worked for 30, 40, or more years and had little to show for it.

At some companies, partners each own 50%. In my experience this split works when everything is going well. It never works when one of the partners stops pulling his weight, wants out, gets hurt, or otherwise loses interest in the business but insists on equal salaries, profit splits, a huge business valuation, and more.

Some family-owned businesses have existed for two or three generations. The original owners teach their children to operate the business. They have the good sense to make the tough choice of choosing one child to operate the business with the majority, if not all, the stock. The original owners leave the business operations on a day-to-day basis and let the children run the company. The children learn from their parents and do the same thing with their children. The family business survives generations because the first generation learns how to pass the business to the second generation profitably. The second learns to transfer the business to the third, etc.

But, what if you don’t have family members who are interested in the business? You’ve built your maintenance-agreement base, the business can operate without you, and you want to be rewarded for your hard work over the years. Where can you turn?

The realities are that buyers for HVACR businesses are slim. You might get lucky and find one. However, multi-million-dollar companies are tough to sell; especially if you want cash for the business and then walk away.

One good alternative is an Employee Stock Ownership Plan (ESOP). An ESOP can be successful for closely held companies where the owner wants to exit, and there are good managers and employees who can eventually operate the business. An ESOP allows a company to gradually buy out its existing owners. Typically, the company makes tax-deductible contributions to a trust set up to facilitate the ESOP. The trust then uses that money to buy stock from the current owners.

Owners have stock that they sell to the ESOP. Employees can purchase stock from the ESOP according to its rules. Everyone has an exit plan. The ESOP purchases their shares when they leave.

It is in everyone’s best interest — owners and employees — to work hard and increase the profits of the company, which in turn increases the value of the stock. An ESOP can be the deciding factor as to whether a potential employee works for your company rather than the competition. At ESOP-owned companies, they have the option to purchase stock and reap the rewards of their hard work while at the company.

About 15 years ago, I was working with a division of a larger company that the parent company was spinning off through an ESOP. I watched as the soon-to-be president of the now successful ESOP company “signed his life away” to purchase the stock. The reality of small-business ownership hit him at that moment. He got stressed out, sick, and didn’t sleep for days. Just as this gentleman experienced, many employees are thrilled to be owners of the company, until the reality of what that ownership means hits them.

In theory, setting up an ESOP is very simple, but experts who know the tax laws as well as the legal ramifications should do it. It can cost $40,000 or more to set up. This cost includes hiring an independent business appraiser hired by the ESOP trustee to establish the stock price.

The ESOP can borrow money to buy new or existing shares, with the company making cash contributions to the plan to enable it to repay the loan. This makes it critical that there is enough company cash flow to support the payments to exiting owners/employees or loans that have been issued.

When employees leave the company, they receive their stock, which the company must buy back from them at its fair-market value. Privately owned HVACR companies must have an annual outside valuation to determine the price of their shares. This is an added expense.

If your company is profitable, has positive cash flow, and employees and managers who can operate the business (or be taught to operate the business), then an ESOP might be your best exit strategy.

Articles by Ruth King

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