Is an ESOP Right for You?

by: Diane Anderson Murphy, ASA and Wayne D. Fjeld, CFA, ASA

A number of dealers at the 2007 RV Dealers International Convention/Expo were interested in Employee Stock Ownership Plans (ESOPs) as a potential exit strategy for their ownership transition plans. We would like to explore this strategy and help you understand if it is the right solution for you.

WHAT ARE THE BENEFITS?
The most common use of ESOPs is to buy the stock of a retiring owner in a closely held company, and, at the same time, provide a retirement plan for employees. Ultimately, ESOPs provide a tool that corporate owners can reward their employees for past and future loyalty and success by giving them an equity ownership stake in the company. There is also a significant tax advantage for the sponsoring company and the selling shareholder.

Several features make ESOPs unique compared to other employee benefit plans. First, only an ESOP is required to invest primarily in the sponsoring employer’s stock. Second, ESOPs are the only benefit plan allowed to borrow money in order to buy the employer stock. The second feature provides significant tax savings to the sponsoring company.

HOW IS IT DONE?
In order to set up an ESOP, the company must create a trust that oversees the plan. The sponsoring company makes annual contributions to the trust. The individual employee collects these contributions throughout his or her career. Upon the employee’s termination, disability, death, or retirement, the Internal Revenue Service (IRS) requires participants to be granted a “put option” exercisable against the employer for fair market value of his or her accumulated stock. This put option creates a “repurchase liability” for the sponsoring company.

WHAT ARE THE ADVANTAGES OF ESOPS?
Research shows that employee ownership leads to greater employment stability, increased job satisfaction, improved motivation, greater workplace participation, increased firm productivity, and increased profitability. Evidence suggests that combining employee ownership with increased employee participation, may generate above average returns on investment.

This exit strategy truly rewards valued employees and the management team for helping build a successful company. It is also well suited to business owners who wish to leave a legacy.

There are two types of tax advantages that are important to understand for ESOPs. First, the sponsoring company can deduct both principal and interest payments for the payments made on the debt financing for the stock purchased from the business owner. There are limitations for these deductions tied to the payroll dollars of the business. The other primary tax advantage is the potential deferral of capital gain for the selling shareholder if he or she invests the proceeds in qualified investments, which are generally U.S. corporation stocks and bonds (not mutual funds or government securities).

WHAT ARE THE DISADVANTAGES OF ESOPS?
There are certainly some disadvantages in establishing an ESOP. The company’s plan documents, plan administration, annual valuations, and annual tax filings are all subject to oversight by the Department of Labor (DOL) and the IRS. It is essential to utilize professionals who have good depth and previous experience dealing with ESOPs to establish and administer the plan. Should an inexperienced advisor give improper advice, it can create havoc years later when a DOL audit uncovers a potential problem.

There are significant professional expenses incurred to establish an ESOP. However, they are significantly less than a brokerage fee for selling the business. Once the ESOP is established, there needs to be an independent business appraisal at least annually. There are also administrator fees that are typical with any retirement plan. Initial costs range from $50,000 or more depending on the complexity of the deal; and annual costs range from $10,000 to $40,000.

For business owners looking to achieve the maximum cash price, an ESOP is not the greatest fit. ESOPs are not a strategic buy. Once the ESOP is a shareholder, the trustee must monitor and ensure that plan participants, and their interests, stay unharmed. This can be especially hard when the trustee is the former/current owner because of change in distribution levels or changing officer compensation.

Frequently, business owners have to personally guarantee company debt or provide financing to the ESOP themselves if a third party finances the sale of stock. Often, the selling shareholder will take a seller note since he or she would have had to guarantee the debt anyway.

There is some concern regarding the concentration of retirement benefits in the employer’s stock. However, evidence suggests this is generally not a significant threat. Offered in conjunction with a 401(k) plan, ESOPs give the employee an alternative form of deferring income.

WHAT COMPANIES ARE SUITABLE CANDIDATES FOR ESOPS?
For RV dealers, we generally like to see annual revenue of $15 million or more and approximately 20 employees.

Companies that embrace an ownership culture are most likely the ones to recognize enhanced productivity, efficiency, and return. Implementing an ESOP in and of itself will not likely lead to improved performance.

Since ESOPs are generally leveraged buyouts, the company should have stable profitability in order to service the debt.

ESOPs are most often a business succession tool, which is a process that consumes time and energy. This is typically not a cut and run strategy. Most importantly, identify the next management team and repay the debt of the ESOP and the employees can enjoy the continued success of the sponsoring company. Many companies can make an ESOP work. The more appropriate question is whether it is the ideal solution for your dealership.

Moss Adams serves over 500 dealerships nationwide, providing, creative solutions to clients’ complex issues. For more information contact them at (800) 905-520 or visit their website at www.mossadams.com.