Stock Ownership Plans Can Benefit All Parties

Do you spend more time thinking about retiring than you do running your business? Would you rather play golf than begin the ordeal of finding buyers for your company and negotiating a sale?

Your buyers might be closer than you think; in fact, you see them every day. And they might be in position to offer you a better deal than any outside investor, even if they command little or no capital of their own.

Who are the buyers? Your employees--and the deal is an employee stock ownership plan.

Technically, an ESOP is an employee benefit plan, and most business owners set them up to give their employees an incentive to work hard. But you can also use an ESOP to finance the sale of your business, reaping benefits not only for your employees but also for yourself.

Congress began promoting ESOPs with the Employee Retirement Income Security Act of 1974, which sets out the statutory framework for ESOPs. At present, nearly 9 million American workers own part or all of their companies through about 11,000 ESOPs in virtually every segment of U.S. industry, according to Corey Rosen, executive director of the National Center for Employee Ownership, a nonprofit ESOP information group based in Oakland.

ESOPs come in many forms, but most employees own only minority interests in their company’s stock. But to the business owner who dreams of retiring, ESOPs offer these advantages:

* They make it easy for your employees to raise capital to buy you out.

* They allow you to defer taxes on the money you receive from the sale.

* They’re easy to do--often far easier than a sale to an outside investor.

* They turn employees into motivated owners with a stake in the well-being of your company.

* Best of all, they give managers an even bigger stake in the business you worked hard to build, making it more likely that the company will live on.

How do ESOP deals work?

Let’s say you run a good business with a healthy cash flow and a solid team of 10 senior managers. You would consider $35 million a fair price for an outside buyer.

But you think your employees stand a better chance of growing your company than any outsider; after all, who knows your business better than they do? In any case, you want to reward them for their loyalty and hard work.

In a simple deal, you set up an ESOP, and the ESOP borrows money from a bank to buy your stock. Banks consider such loans relatively low risk; a recent study showed default rates of some ESOP loans to be about half that of ordinary business loans, according to Rosen.

Your company makes “contributions” to the ESOP, with which the ESOP retires the bank debt over, say, five years.

These contributions are tax-deductible expenses to the company, just like contributions to any pension plan or 401(k). The deductions improve the company’s cash position, easing the burden of debt service.

You, meanwhile, have taken advantage of another tax break in negotiating your sale price. Federal law allows you to defer capital gains taxes on stock sold to an ESOP, so you have discounted the price of your stock to reflect the tax break.

For example, were you to sell to an outside investor for $35 million, you would pay about $9.8 million in capital gains taxes, assuming federal and state taxes equaling 28%.

Put another way, you must gross $35 million to net $25 million after taxes--so if you don’t owe the tax, why not discount your price? Doing so, of course, benefits your employees by reducing the debt they take on to buy you out, once again easing the sale.

In any case, after the ESOP retires the debt, it becomes the sole owner of the stock, with shares allocated to the accounts of the employees to reflect compensation. In plain English, this means that everybody gets a piece of the action, and managers get the biggest pieces of all because they earn the highest wages.

You, meanwhile, play golf every day, having sold your company to people who have a stake in keeping it going. Even better, you defer capital gains taxes on the cash in your pocket if you reinvest it in the stocks and securities of going companies (but not in mutual funds).

In essence, according to Martin Sarafa, a director of the investment banking firm Houlihan Lokey Howard & Zukin, such a sale is a leveraged buyout--that is, the sale of company stock financed by debt. The tax advantages inherent in ESOP law make the deal possible.

As an alternative, Sarafa says, you can structure a more complicated ESOP to put your company even more solidly in the hands of your managers.

In this scenario, you would sell one-third of your company to an ESOP, and the rest to your management team in a separate deal. Your 10 managers raise $100,000 each, or $1 million total, perhaps by borrowing it, perhaps by mortgaging their homes or tapping their pension or 401(k) plans.

Working with an investment banker, they strike a deal with an investment group to raise an additional $19 million in senior debt and equity, Sarafa says. The ESOP borrows $10 million, making the total sales price $30 million.

You owe $5.6 million in capital gains taxes on the deal with your managers, but nothing on the sale to the ESOP, so your net comes to $24.5 million--very nearly the same as in the earlier example.

Once again, the ESOP pays off the $10-million debt, and your managers pay off the outside investors. When everything shakes out, Sarafa says, your managers own a controlling interest in the company, and your employees have their own stake in the future.

You’re still playing golf.

“In doing a buyout with an ESOP,” Sarafa says, “you’re doing an inside, confidential deal. It’s usually faster than taking your company to market and running a sale process.

“That can take six months easily, sometimes a year. An ESOP deal can be done in 90 to 120 days, and if you do it properly, everybody benefits.”

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How to get financing will be a topic of The Times’ Small Business Strategies Conference Oct. 17-18 at the Los Angeles Convention Center. Columnist Juan Hovey will be featured. He can be reached at (805) 492-7909 or via e-mail at jhovey@gte.net.