Here's why an ESOP might be a great idea
Columbus entrepreneurs Todd Kaufman and Justin Searls sold their rapidly growing software consulting agency Test Double to their employees in April. They converted to an employee stock ownership plan, which cost employees nothing, allowed Kaufman and Searls to remain at the helm and positioned the company for accelerated growth over the next several years.
ESOPs are an exit strategy that offers significant tax benefits to both sellers and employees, protects company culture, and rewards and retains employees by putting equity in their hands.
ESOPs have gained traction locally and nationally over the last four years. Numbers could jump even higher if legislation introduced in July by Sen. Ron Johnson (R-Wisconsin) to create a temporary federal ESOP grant program moves forward as a way to support businesses struggling through the pandemic.
Selling to an ESOP can be a lucrative alternative to a merger or sale to a third-party buyer. ESOPs are the most common form of employee ownership in the U.S., according to the National Center for Employee Ownership—more popular than profit-sharing plans or allowing employees to buy directly or receive stock options.
As an ESOP, Test Double no longer pays federal income tax. Kaufman and Searls retained their leadership positions and added a board of directors and a trust that manages employees’ shares of the company.
“It’s retirement on steroids,” says Kaufman. Employees receive shares allocated based on income and are fully vested within six years of their date of hire.
Columbus-based investment bank Lazear Capital Partners specializes in ESOPs. Partner Ted Lape says the company helped complete 16 new ESOPs in 2019 and is on pace to do even more this year. Their popularity continues to grow as companies with misconceptions learn more about the benefits and advantages.
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Lape explains that an ESOP is a retirement plan, like a 401(k), that doesn’t pay taxes. It allows owners to sell their company tax-free and then move forward tax-free. Up-front costs roll into the financing.
“The most simple reason people do ESOPs is that they end up with more money—middle market kinds of companies,” Lape says. Companies usually get a valuation similar to if they sold to a competitor and then receive significant tax benefits.
Lazear Capital Partners saw 80 percent of clients choosing ESOPs, so it developed the specific knowledge and contacts to walk clients through the ESOP process, which involves various players including a trustee, a bank, attorneys, a valuation firm, accountants, wealth managers and insurance contacts.
Lape says ESOPs are ideal for companies with at least 20 employees, a cash flow of $1.5 million and owners who want to continue working three to 10 years. Stable earnings, good debt capacity and strong management also make companies strong candidates.
Brent Thomas, senior vice president and commercial banking manager with Fifth Third Bank, sees four key reasons businesses consider an ESOP.
A top reason is that ESOPs allow selling shareholders to continue managing the business if they’re not looking to retire and liquify their investments.
Though Test Double had grown to 50 employees since its 2011 inception and was working its way up the Inc. 5000 list of fastest-growing privately held companies, the owners were looking long-term at potential exit strategies. Kaufman says he and his co-founder weren’t quite ready to step away, but “over the next five to 10 years, we couldn’t be 100 percent sure we could devote all of our time and energy to this company.”
The ESOP process takes four to six months, and sellers typically make their money back within five to seven years.
Thomas says Fifth Third is one of only a handful of banks nationally with a specialized ESOP group, but he anticipates growth in the number of ESOPs, especially in the Midwest and Columbus region.
“There are 66,000 businesses greater than 100 employees owned by baby boomers, according to the Census—most of these businesses are positioned for ownership transition,” he says.
Many of Lazear Capital Partners’ clients also cite ongoing owner involvement as a major reason for choosing the ESOP option. “Baby boomers’ lives are intertwined with the company. A lot of who they are is the legacy of this company and seeing it grow,” Lape says.
The second major benefit of the ESOP structure is the unique opportunity for owners to reward employees.
According to a 2018 survey by the National Center for Employee Ownership, ESOP participants have twice the total retirement balance of Americans nationally. Thomas says he’s seen employees retire with $1 million or more in their ESOP.
“For employees, it’s the gift that keeps on giving. But it’s been well-earned,” Thomas says.
At Test Double, Kaufman says the ESOP moved the money that used to go to the owners to the business, making it a “perpetual reinvestment machine for employees” and generating added buy-in from employees.
ESOPs also assure continuity of company culture because there’s no third party making decisions.
Potentially the biggest benefit of an ESOP is the significant tax savings for all parties.
“As loans get paid off, it means the company could start sitting on a lot of cash,” Kaufman explains. “That can be leveraged for strategic investments or acquisitions.”
Thomas emphasizes that companies considering an ESOP should plan well in advance and surround themselves with professionals who understand ESOPs to ensure they remain in full compliance during and after the transaction. “There are a lot of ways to describe an ESOP, and simple isn’t one of them,” he says.
Kaufman feels good about the decision to convert Test Double to an ESOP, but recommends that companies take the time to examine their priorities and do their homework on different exit strategies.
“The smartest thing we did was to take it extremely slowly and examine all options on the table.”
Mary Sterenberg is a freelance writer for Columbus CEO.
Is your company right for an ESOP?
Many factors come into play when company owners are considering selling to an employee stock ownership plan.
- Middle market range of $10 million to $1 billion annual revenue
- Cash flow of $1.5 million
- Predictable earnings
- Mature company that’s been around for several years
- Not overly leveraged
- 20 or more employees
- Owners who want to continue working for awhile
- Corporate culture that can accommodate a shared management style
- Companies with existing retirement plans