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Practice Management > Building Your Business

Bring The Magic Of ESOPs To Your Clients

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I am excited to share with you an incredible win-win opportunity for you and your clients: ESOPs, or employee stock ownership plans.

With an ESOP, your clients can:

o Obtain liquidity for some or all of their shares tax deferred,

o Reduce or even eliminate most future corporate income taxes,

o Provide a great retirement benefit for their employees at no additional cost to the employees, and

o Still retain control of the company.

Furthermore, every ESOP transaction provides the need for many financial products for you to sell that pay commissions.

For example:

o When an owner sells to an ESOP, the owner receives cash and must reinvest that cash.

o When there is a sale to an ESOP, you have to revise the buy-sell agreement because you have new owners. Often they need more buy-sell insurance for remaining shares.

o Because an ESOP is a business succession planning transaction, we need key-person life and disability insurance for the next generation of management. If something happens to key individuals, the owner will be at a loss from a planning and financial standpoint.

o For the same reasons, the owner needs to protect against next-generation managers leaving on their own. So, we need to look at golden handcuffs and other executive compensation planning ideas for these people.

o Next the selling owners may need a nonqualified plan if they continue with the company.

o Because the selling owners’ assets have changed, they need to review their estate plans and often have cash for their charitable giving. I have heard hundreds of owners tell me, “I am unique. I have provided enough for my family. What I would like to do is sell my business to my employees and give some or all of the proceeds to charity.”

o The ESOP needs financing. The bank may require additional insurance on the owners and executives.

o The company will have to repurchase the shares from employees in the future. In many cases, this obligation should be funded by insurance or a sinking fund.

o Oftentimes, clients will move their 401(k) to my company to have a single company administer their ESOP, nonqualified plan and 401(k) plan to receive all of their retirement benefits on a single platform, Website and statement.

As an advisor, you can receive commissions from each of these products. So, the fact that you cannot get a commission on the sale of the ESOP is quickly surpassed by the incredible opportunities that occur as a result of the sale.

And the best part is that you have an independent consultant–me–telling the clients that they need these additional products and that they should talk to you because you are the expert in providing these financial products.

Steps To An ESOP

Every good transaction must start with a solid foundation. We help the company and owners understand the ESOP transaction, how it works, and what the benefits will be for everyone involved.

We prepare a financial analysis to design the transaction and nonqualified plans to make sure that everyone is happy with the design of the transaction today and five and 10 years in the future. We want a long-term relationship with the client; so we do a thorough analysis and projection to make sure the design will stand up to the long term.

Next the company needs to get an independent valuation and have a trustee negotiate the purchase price. The company will need to borrow from a lender and have attorneys draft all of the legal documents. Then you come in with the planning for the seller and the company. We help the company administer the plan and communicate it to the employees.

In a closely held company, ESOPs can:

o Improve work force motivation and employee retention. We work with a lot of community banks that set up ESOPs to give employees an ownership interest (typically between 5% and 10%) for motivation and retention purposes. Given the consolidation in the financial services industry, an ESOP is a way to reward employees in the event of an acquisition.

o In an S corporation, create fully federal tax-sheltered earnings. We’ve design ESOP transactions for more than 40 employee-owned architecture and engineering firms. By becoming 100% ESOP-owned, the firms don’t pay taxes on income that isn’t distributed as wages. These companies can retain capital needed for bonding and growth of the business. The ESOP has been a very successful structure for many of these firms.

o Provide partial liquidity for active or inactive shareholders. I have a client who promised his investors that he would make them millionaires. After a period of time he did, but he did not want them to ask to sell. So, he designed a 30% ESOP transaction to give them about $10 million.

Now, he can continue to run the company with the expectation that they will stay invested for the next 10 years. Without giving them partial liquidity, they would have asked for a sale.

o Create a controlled market for closely held shares at objectively determined value. Several of my clients used the ESOP to create a market for third-generation shareholders who were not in the business. The third generation in the business wanted the cash in the business, and the third generation outside the business wanted dividends. By creating the ESOP, the shareholders who wanted to sell had a market.

o Assist in acquisitions.

o Serve, in conjunction with a GRAT, as a vehicle for passing the business to the next generation and for creating liquidity for the retiring generation and heirs outside of the business.

What are the characteristics of a good ESOP candidate? An ideal candidate is:

o A closely held corporation (C or S corporation).

o A firm wherein one or more owners is nearing retirement or wanting liquidity.

o A firm with a history of profitability. The company has to be a good investment for employees. Otherwise the trustee will not buy the stock. If a company has $1 million in earnings before interest, taxes, depreciation and other adjustments (EBITDA), it is probably worth from $5 to $6 million.

You can do ESOPs with smaller companies, but they often are not willing to spend the money needed to do the transaction right and maintain the ESOP after the transaction. An ESOP is not for the lowest bidder because you will pay more and have more frustrations afterward.

o Firms wherein successor management is in place or in the wings. If there isn’t good management in place, we do not want to work with the company because it has a high chance of failing.

o Firms that have corporate credit available. You have to be able to borrow to create the liquidity. We do a lot of transactions where the seller finances all or part of the transaction. But that isn’t the normal starting place.

o Firms that are comfortable with the concept of employee ownership–sharing value but not control.

o Firms that have a minimum of 50 employees. This isn’t a hard and fast rule as long as the company is profitable.


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