Increasingly, closely held business owners are turning to Employee Stock Ownership Plans (ESOPs) to create liquidity from their businesses. Part of this is due to the changing M&A landscape after the recession, partly due to the aging of baby boomer business owners, and partly due to the recently improved designs for ESOP transactions.

An ESOP is a qualified retirement trust used as a tool of corporate finance that generates tax deductions and exclusions for corporations, and enables a shareholder to sell all or a portion of his or her closely held stock in a tax advantaged manner. ESOPs offer closely held business owners a more flexible business succession tool than a third-party sale and often create a market for the owner’s stock that might not otherwise be available. As a type of qualified retirement plan, ESOPs also create equity incentives for management and employees.

In a typical ESOP transaction, the corporation borrows money with a combination of senior debt and seller financing (known as the “outside loan”). The corporation re-lends the borrowed money to an ESOP Trust (known as the “inside loan”), and the Trust then purchases stock from the selling shareholder. With sellers holding subordinated debt in their own company, they often elect to receive warrants from the company. Thus, the seller receives upfront cash, a stream of income, and upside growth potential on the stock in the company.

This is how the transaction works: click here to view.

From a tax perspective, selling shareholders like a sale to an ESOP, as they can structure the transaction to permanently avoid paying capital gains taxes (if they are a C corporation at the time of the sale), and the Company also gets large income tax deductions for the repayment of BOTH principal and interest on the acquisition costs.

If the post transaction company is an S corporation in a 100% ESOP buyout, the company is permanently exempt from income taxes, freeing up significant extra cash flow, since the shareholder is a qualified retirement plan. The sellers can now diversify their investments from the cash received, yet continue to have operational control of the company.

Employees like ESOPs because they receive equity without paying current income taxes or investing any capital. Since an ESOP is a qualified retirement plan, the accounts in the ESOP grow tax deferred and when eventually cashed out can be rolled over tax free to an IRA. It is also common to couple an ESOP with a Management Incentive Plan (using SARs) to reward and retain key management.

An ESOP is a “friendly” financial buyer that is created for the sole purpose of buying a shareholder’s stock. The seller will dictate the amount of stock he or she wants to sell and the cash he or she wants to receive at closing. If senior debt does not provide enough upfront liquidity, investment and mezzanine debt can be brought in.

The most typical ESOP candidates are long-term businesses with consistent earnings. Often when there are limited cash options from strategic or financial buyers, the ESOP creates the only available market. An ESOP can also be used as a tax efficient way for one shareholder to buy out another. Since an ESOP allows for a gradual transition, it gives the seller time to develop a capable successful management team, while he or she receives upfront liquidity.

The ESOP transaction has many similarities to a typical M&A transaction. The corporation has legal, accounting, valuation, and investment bankers on its side. An independent “buy side” is created with a trustee representing the employees, with its own legal counsel, and independent financial advisor who will need to issue a fairness opinion.

ESOPs have significant tax and non-tax benefits. Clients must do a careful review of their alternatives before they decide to sell to an ESOP. The ESOP study process involves corporate and tax planning work often utilizing a qualified ESOP advisor who identifies the value of the company and presents the client with alternative structures to sell to the ESOP.