Are ESOP’s really more complicated than other ways to sell or exit your business ? National Centre for Employee Ownership - Succession Plus

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Are ESOP’s really more complicated than other ways to sell or exit your business ? National Centre for Employee Ownership

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Are ESOP’s really more complicated than other ways to sell or exit your business ? National Centre for Employee Ownership

By , December 8, 2012

An interesting comparison by NCEO of the complexities of setting up an ESOP vs selling your business – In our view it is really a matter of matching the right exit to the business, the owner and their needs and goals.
When people describe the pros and cons of ESOPs, often they note that the plans are complex. ESOPs are somewhat more complex than 401(k) and similar retirement plans and do cost substantially more to set up and implement and somewhat more to operate, mostly because an annual valuation is required for closely held companies.
But ESOPs are not more complex than selling to a third party.
The table below compares what issues come up in the sale of a company to an ESOP compared to a sale to a third party. It was prepared with the advice of professionals who have done both kinds of transactions.

The table indicates that the overall level of complexity is similar, but ESOPs are much less risky in terms of the likelihood of finding a buyer. They are also considerably less costly, mostly because in the case of a sale to a third party, in addition to substantial legal, accounting, and sometimes other fees, the price paid to the seller is usually reduced by brokerage commissions paid by the buyer.
ESOP Sale to Another Company
Key legal documents

ESOP plan document
Trust agreement
Lender agreements
Corporate resolutions
Stock purchase agreements
Corporate governance agreements
Employee contracts/management incentives

Detailed selling memorandum
Sale agreement (similar to stock purchase)
Non-compete agreements (often)
Liens, escrow, warranties, security agreement, and personal guarantees
Corporate resolutions
Employee contracts/management incentives

Feasibility studies and preparation Feasibility studies assess whether the company has sufficient payroll and cash flow to buy the desired amount of stock. Can be performed internally or with expert advice. Forensic due diligence rarely needed. Companies must prepare a detailed and accurate description of the firm and its finances, prospects, and risks. Buyers will want to do a forensic due diligence investigation and sellers should do the same to assess the financial soundness of the buyer and the terms of the offer.
Valuation Outside appraisal required; valuation based on fair market value In smaller deals, outside appraisal not required but recommended; in larger deals price usually set by controlled auction/negotiation.
Terms and risks Plans can be structured in a variety of ways:

Flexibility in financing
Rules for operating the plan must comply with ERISA, but there is lots of flexibility in design.
Escrow may be, but usually is not, required.

Buyers will typically have multiple contingencies:

Earn-outs often required, often in the 10% to 20% range.
Escrow held back
Purchase price adjustments in companies that underperform post-transaction may be required based on working capital or earnings requirements
Buyers prefer to purchase assets, with potential tax and liability implications for sellers.
Financing may fall through

Time to sell Once the seller has decided on doing an ESOP and its basic structure, four to six months. Average formal offer to sale time is 10 months for companies in the small to mid-market range
Role of seller post-transaction Flexible depending on seller interests Buyer will usually determine role in smaller deals; in large deals role is usually negotiable.
Sale of minority interest ESOPs can buy any percentage of stock from any number of sellers Buyers almost invariably want to buy the entire company
Success rates If an ESOP is determined to be feasible, only rarely do transactions fall through once a decision to proceed has been made Overall, only about 25% of privately held businesses put up for sale are sold and only about 50% of businesses with 100 or more employees are sold.
Transaction costs

For most closely held companies, between $20,000 and $50,000, with a minority in the $50,000 to $100,000 range.
A small number of ESOPs will require investment banking assistance to raise financing, adding to costs.
No broker fees should ever be paid in an ESOP
The ESOP pays the due diligence, financing, and legal fees.

Legal costs may be somewhat lower.
Feasibility and due diligence comparable to or higher than ESOPs, and considerably higher in larger deals.
Legal costs are similar for smaller sales and much higher for large sales. Appraisal costs, if needed, would be similar.
The buyer usually pays the diligence, financing, and legal fees. Broker success fees are generally between 3% and 8% of the sale price in sale prices under $5 million and drop as low as 2%-5% in larger transactions.

Craig West

Craig West

Managing Director | Succession Plus

Craig West is a strategic accountant who has over 20 years’ experience advising business owners. His background as a CPA in public practice, provided invaluable experience in the key issues of concern to business owners. Following 6 years of study to gain two masters degrees, Craig focused on Capital Gains Tax (CGT) for business sales advising on strategic management of tax issues. This experience formed a very strong view that business owners (and often their advisers) were unprepared and unaware of the steps required to prepare a business for exit.

Craig now acts as a strategic mentor for mid-market business owners and has written four critically acclaimed books on employee incentives, succession planning, asset protection and exit strategies. Craig has conducted numerous seminars and keynote presentations throughout Australia & internationally, including adviser education programs for the Institute of Chartered Accountants and CPA Australia.